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Economic
•»»i-i Review
FEDERAL RESERVE BANK OF ATLANTA
MARCH/APRIL 1990
De Novo Bank Performance
FEDERAL RESERVE BÀ
OF PHILADELPHIA!
A PROPOSAL
TO EASE
LDC DEBT
Call Options on Commodities
W E. B 5 f t R
Economic
Review
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ISSN 0 7 3 2 - 1 8 1 3
V O L U M E L X X V , N O . 2, M A R C H / A P R I L 1990, E C O N O M I C R E V I E W
Covered Call Options:
A Proposal to Ease LDC Debt
Steven P. Feinstein and Peter A. Abken
J 4
2
Determinants of
De Novo Bank Performance
This article proposes a method by which less
developed countries can reduce their massive
d e b t b u r d e n s - s e l l i n g covered calls on their chief
export commodities.
Which factors are most influential in determining a
William C. Hunter and Aruna Srinivasan
newly chartered i n d e p e n d e n t bank's probability of
success?
F.Y.I.
Measuring Interstate Migration
William ). Kahley
4 J
Book Review
Larry D. Wall
The Separation of Commercial and
Investment Banking: The Glass-Steagall Act
Revisited and Reconsidered
by George J. Benston
COMMODITY FUTURES
NVrjch 11,
Covered
Call Options:
A Proposal to
Ease LDC Debt
Steven P. Feinstein and Peter A. Abken
The large debt burden carried by many developing
nations not only has hampered these countries' economic
development but has also threatened their commercial
bank lenders. Economic austerity measures aimed at
reducing this debt have severely limited the funds less
developed countries have available for domestic investment, further retarding their economic growth. The
authors' proposal—that LDCs sell long-term, high strike
price call options on their chief export commodities—would
allow LDCs to generate revenue without renegotiating
existing debts or giving up ownership of productive
resources.
any less developed countries (LDCs)
struggling to pay off massive loans
p o s s e s s an untapped, e x p o r t a b l e
resource for which a demand exists in develo p e d nations. Revenue from such a resource
would not only help to service d e b t s but also
further the i n d e b t e d developing countries'
economic advancement. This potential source
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of d e b t relief is not a physical commodity but
rather a type of financial asset—namely longterm, high strike price call options on their chief
export commodities.
The proposal in this article offers interested
parties such as commodity users or speculators
the opportunity to bid on the right to purchase a
certain quantity of a chief export commodity for
E C O N O M I C R E V I E W , M A R C H / A P R I L 1990
a prespecified price on a given future date. In
making these call options available, LDCs would
in effect b e sel ling commodity price i n s u r a n c e insurance that pays off if the commodity price
rises beyond s o m e high level. For example, a
bidder might purchase the right (but not the
obi igation) to buy Mexican oil at $27 a barrel on a
given date five years hence, even though the
price of oil at the time of bidding is only $ 17.25.
Should the prevailing market price remain b e low the "strike" level of $27, the option owner
would simply elect not to carry out the transaction. 1 Should oil rise to $30 a barrel by t h e
agreed-upon expiration date, though, the bidder could purchase the oil at $3 below prevailing prices. Although the LDC must then relinquish g o o d s for l e s s than t h e going rate,
revenue from the earlier option sales would
have ameliorated matters during a period of low
prices. The loss of potential profits would c o m e
at a time of high prices when the selling country
could b e s t afford it.
Using call options in meeting d e b t obligations is not an entirely new idea. Numerous
articles in academic journals have suggested
construction of financial instruments that tie a
borrower's liabilities to a commodity price, and
the recent Mexican loan restructuring (described
below) includes such a feature. 2 In other plans,
however, options have b e e n bundled together
with bonds. By selling options separately, as
proposed here for the first time, an LDC can
generate substantial revenue without renegotiating all its outstanding debts.
Such an "unbundled" approach is possible
with this proposal b e c a u s e it calls for selecting a
strike price high enough to e n s u r e that t h e
debtor will face the future obligation only when
fulfillment of all other obligations is relatively
easy. This feature would obviate the n e e d to
gain the endorsement of existing creditors prior
to selling the options. Keeping the options
separate from d e b t instruments also affords the
LDC greater flexibility in the management of its
revenue flow and debt. A program of selling
options when commodity prices are low and
redeeming them when prices are high can help
an LDC smooth revenue across periods of high
and low commodity prices. A further advantage
is that the market for the unbundled option is
likely to b e wider than the market for options
coupled with d e b t .
The World Debt Problem—A Review
Since 1982 the high i n d e b t e d n e s s of many
developing nations has placed a severe strain
on both the LDCs and the world banking community. According to the most recent accounting, LDCs owe $1.3 trillion to foreign banks,
governments, and international agencies. 3 Not
only have LDCs struggled to service this debt,
b u t e x p o s u r e to t h e s e t r o u b l e d loans has
threatened the strength of commercial banks.
T h e roots of the problem can b e traced to the
volatility of commodity prices and interest rates
over the last two decades. The oil price increases
of 1973 and 1979 led to a massive redistribution
of wealth from oil importers to oil exporters,
primarily those in the Middle East. T h e s e "petrodollars" accumulated in commercial banks
around the world as surplus funds awaiting investment opportunities. Because of their apparent excellent potential to develop rapidly,
Latin American economies were d e e m e d to b e
excellent credit risks. As a result, t h e s e countries received enormous loans from commercial banks.
T h e loans were predominantly short-term,
with interest rates tied to the London Interbank
Offer Rate (LIBOR).4 By 1980 three-fourths of the
d e b t owed by Latin American countries was s e t
at variable rates; 40 percent was due for repayment within one year, and 70 percent within
three years. 5 From 1971 to 1980, LIBOR was on
average 0.8 percent (80 basis points) less than
the rate of U.S. wholesale price inflation; developing countries were effectively borrowing at
very low or even negative real interest rates. 6
Later, however, rates on LDC d e b t surged as the
United States tightened monetary policy in an
attempt to control inflation. LIBOR averaged 9.2
percent (920 basis points) above the U.S. inflation rate from 1981 to 1982. 7 As rates rose, d e b t
service obligations soared.
The worldwide recession that accompanied
higher interest rates further hurt LDCs. Reduced
The authors are economists in the financial section of the
Atlanta Fed's research department. They would like to thank
Marco Espinosa, Larry Wall, and Robert Kahn for helpful
comments. They gratefully acknowledge research assistance provided by Karen Hunter and Hermawan Djohari.
The authors accept sole responsibility for any errors.
I7
FEDERAL RESERVE BANK O F ATLANTA
d e m a n d for their exports and plummeting c o m modity prices c o m p o u n d e d their misfortune. As
t h e value of imports began to overwhelm that of
exports, current account payment b a l a n c e s of
t h e highly i n d e b t e d countries turned sharply
negative. 8 By t h e e n d of 1982, 34 developing
c o u n t r i e s w e r e u n a b l e to s e r v i c e their d e b t
fully. 9 As oil exporters, Mexico and Venezuela
were special c a s e s . As oil prices leveled off and
then b e g a n to drop, however, t h e s e two countries also began to have difficulty making payments on t h e substantial d e b t they had accumulated against future oil revenues.
T h e p r e d i c a m e n t has taken a heavy toll on t h e
LDCs. In net terms Latin America and t h e Caribb e a n exported capital in each of t h e last eight
years; t h e 1989 net outflow a m o u n t e d to $24.6
billion ( s e e Barbara Durr 1989). As a result,
d o m e s t i c investment and d e v e l o p m e n t have
suffered. Growth over t h e last d e c a d e has slowed
to a crawl, making r e p a y m e n t of t h e foreign d e b t
even m o r e difficult and less likely. 1 0 Moreover,
standards of living have declined. B e t w e e n 1980
and 1987, per capita consumption in t h e LDCs
fell nearly 12 p e r c e n t (see Giancarlo Perasso
1989, 535). If t h e quality of life for t h e citizens of
LDCs is to improve, many believe, capital must
flow into t h e s e c o u n t r i e s on net, n o t in t h e
o p p o s i t e direction.
L e n d e r s have also suffered. In 1982 t h e sum of
LDC loans on t h e b o o k s of U.S. banks was over
180 p e r c e n t of t h e capital in t h o s e banks (Jeffrey
Sachs 1989a). S i n c e then, t h e market value of
LDC loans has fallen sharply below b o o k value.
For e x a m p l e , by March 1990, Peruvian loans
c o u l d b e sold for only six c e n t s on t h e dollar,
and t h e market valued Mexican d e b t at 40 perc e n t of face value. 1 1 Consequently, bank earnings have suffered, and b a n k stocks have ref l e c t e d d e t e r i o r a t i n g loan p o r t f o l i o v a l u e s
(Sachs 1989a).
Nonetheless, considerable progress has b e e n
m a d e toward alleviating t h e crisis. Banks have
r e d u c e d their LDC loan e x p o s u r e and increased
capital, t h e r e b y easing fears of bank insolvency.
By 1988, aggregate e x p o s u r e stood at l e s s than
80 p e r c e n t of capital (Sachs 1989a). This improvement afforded s o m e breathing room and
m a d e it p o s s i b l e for banks to offer d e b t relief.
R e c e n t l y , U.S. Treasury S e c r e t a r y N i c h o l a s
Brady's initiative to r e d u c e LDCs' d e b t burden
h e l p e d Mexico restructure its commercial b a n k
4
d e b t . Mexico received c o n c e s s i o n s on principal
and interest, along with new loans (Peter Truell 1990).
T h e LDC d e b t problem, however, is far from
over. No single approach is likely to work across
t h e board, and in m o s t e a s e s d e b t reduction will
probably b e part of future financial arrangements. Yet developing countries that rely solely
on d e b t reduction may find it difficult to borrow
in t h e future. Nor is rescheduling old loans and
securing new loans a satisfactory long-term solution. Many e x p e r t s now agree that t h e problem is o n e of solvency rather than a lack of
liquidity available to t h e LDCs (Anna J. Schwartz
1989). In other words, t h e s e nations' e c o n o m i c
p r o s p e c t s are sufficiently b l e a k that markets
doubt LDCs can make good on their past financial
obligations. Consequently, as long a s stretching
payments out over longer horizons p r e s e r v e s
t h e net p r e s e n t value of LDCs' liabilities, such a
tactic will not end t h e crisis.
Highly i n d e b t e d c o u n t r i e s m u s t t h e r e f o r e
search for ways t o restore their solvency. Essentially, in order to pay off their huge d e b t s , they
must raise more revenue. B e t t e r e c o n o m i c planning and m e a s u r e s to s t e m d o m e s t i c capital
flight are t h e sorts of actions that will have lasting positive effects (A. Schwartz 1989 and Rudiger Dornbusch 1987). S o m e policymakers and
analysts advocate d e b t - e q u i t y swaps a s m e a n s
by which LDCs can pay off loans without incurring new liabilities; however, t h e s e transactions
r e p r e s e n t p e r m a n e n t s a l e s of an LDC's productive resources (such as forests, mines, and factories) a n d s o c a n n o t p r o v i d e r e v e n u e on a
continuing basis. C o n s e q u e n t l y , such swaps
serve only as temporary palliatives. Furthermore, t h e manner in which d e b t - e q u i t y swaps
are e x e c u t e d usually results in money supply
expansion in t h e LDC, thus fueling inflationary
pressures. 1 2
A New Proposal
Selling high strike price call options on export
c o m m o d i t i e s is o n e way LDCs could g e n e r a t e
revenue without selling their productive resourc e s or renegotiating existing d e b t . Thus c o m modity price volatility, which contributed to t h e
d e b t crises in t h e first place, could provide a
E C O N O M I C R E V I E W , M A R C H / A P R I L 1990
partial key to its solution. It is precisely the
volatility of LDC export prices that makes high
strike price call options valuable today, just as
uncertainty makes various forms of insurance
more desirable.
Because a call option affords the buyer the
right, but not the obligation, to buy at a given
price on a given date, investors find it profitable
to exercise the option only in the event that the
commodity's market price rises above the strike
price. Thus, an LDC that sells high strike options
incurs an obligation that n e e d s to b e fulfilled
only if commodity prices increase substantially—
a circumstance in which fulfillment of all obligations would b e easier for the LDC.
Selecting a high strike price for the call options enhances the instrument's marketability.
High strike price call options n e e d not b e
designated as "senior" obligations (those that
must b e met in advance of existing debt) in
order to attract buyers. Although call option
transactions entail s o m e risk of default, t h e
option's value remains high, even when default
risk and junior designation are taken into consideration, b e c a u s e the chance of default is
small when the commodity reaches the high
strike price. (See the example of option pricing
in the box on page 10.) As junior obligations,
option s a l e s would not require approval by
existing creditors—an obstacle that frequently
blocks additional loans to highly i n d e b t e d
countries.
Since LDCs would b e issuing call options on
their own export commodities, the countries
would bear little financial risk in meeting their
obligations. When calls are covered, the issuer
simply sells the available commodity to the
option holder for the strike price. When call
options are not covered, that is, when the underlying commodity is not in the possession of
the issuing party, the issuer takes the chance of
having to purchase quantities of the commodity
at high prices to fulfill the contract.
LDCs could either sell covered calls to new
investors or swap them for a portion of outstanding debt. To ensure a fair price to the LDC for the
calls, the sale and distribution could b e conducted via a closed-bid auction in a manner
similar to the Morgan Guaranty Mexican debtswap of February 1988. LDCs could s e t a minimum acceptable price in advance, or they could
retain the right to reject low bids.
The covered call is a simple use of options.
Additional flexibility could b e achieved through
use of combinations of options, which would, for
example, keep an LDC from sacrificing all of the
additional revenue forgone if prices rose above
the strike price. A more elaborate use of options
could tailor the payoff contingencies to b e t t e r
suit the LDC and potential investors.
One such strategy is the call option spread,
which would provide a cap on the payout in the
event of a very high commodity price. A spread
is conceptually equivalent to the LDC's selling a
call at a given strike price and simultaneously
buying a call at a higher strike price. 1 3 This combination entitles the investor to an increasing
payout as the commodity price rises in the range
between the two strike prices. If the commodity
price rises further, though, the cap c o m e s into
play. LDC governments might prefer this arrangement for pol itical reasons. Setting a cap on
the contingent liability would also b e advantageous in the c a s e of agricultural commodities,
for which quantity risks caused by uncertain harvests are significant.
Supporting Theory
As is nowclear, the LDC is not the only party to
bear commodity price risk; the LDC's creditors
share that risk. While periods of high prices are
characterized by large capital inflows and rapid
growth, low prices strain LDC economies and often result in d e b t crises as the revenue n e e d e d
to service outstanding d e b t dries up. At the same
time d e b t held by the LDC's creditors fluctuates
in value according to the LDC's creditworthiness, which in turn d e p e n d s on the commodity
price. If the risk of price fluctuation s u b j e c t s
both the LDC and the creditor to the specter of
default during low-price times, and if default is
costly to the two parties, then s o m e sort of revenue smoothing is advantageous to both parties.
One way to smooth revenue across high- and
low-price periods is for the LDC to sell "claims"
on the high-price period. High strike price options are exactly such a claim. They allow the
LDC to transfer money from potential high-price
periods into an immediate low-price period.
According to option pricing theory, the more
volatile the commodity price is, the more such
I7
FEDERAL RESERVE BANK O F ATLANTA
Table 1.
Estimated Value of Vulnerable Oil Options
For Various Terms and Strike Prices
(Johnson-Stulz Pricing Method: Spot Oil Price = $17.25;
Oil Price Volatility = 28 percent per year; Initial Pool Value = $10.77 per option;
Pool Volatility = 42 percent per year; Correlation between Oil Price and
Pool Value = .5; Interest Rate = 8 percent per year)
.
0,
Strike
pnce
per barrel
Years until expiration:
2
3
4
5
6
7
$25
$1.27
$2.01
$2.59
$3.04
$3.39
$3.65
26
1.11
1.83
2.42
2.88
3.23
3.51
27
.96
1.67
2.25
2.72
3.09
3.38
28
.84
1.51
2.10
2.57
2.96
3.25
29
.73
1.44
1.95
2.43
2.84
3.13
30
.63
1.25
1.82
2.30
2.70
3.01
31
.55
1.14
1.69
2.17
2.57
2.89
32
.48
1.04
1.58
2.06
2.46
2.78
an option is worth. Consequently, t h e u s e of
LDC c o v e r e d calls is m o s t f e a s i b l e in exactly
t h o s e c a s e s where it is most necessary.
An Example of an LDC Covered Call
While t h e features and theoretical underpinnings of LDC covered calls are straightforward, a
realistic e x a m p l e can clarify t h e features outlined. Mexico o w e s $ 1 0 0 . 3 billion t o foreign
interests. 1 4 Payment of principal and interest
e x c e e d e d $15 billion in 1988, an a m o u n t equal
to 4 6 p e r c e n t of export r e v e n u e s . 1 5 Yet Mexico
consistently produces b e t w e e n 880 million and
1.1 trillion barrels of oil each year. S i n c e 1982
over 4 7 0 million barrels per year have b e e n
e x p o r t e d . 1 6 Proven reserves amount to 70 billion barrels. Thus, t h e supply and production of
Mexican oil is reliable.
Under conditions prevailing in t h e s e c o n d
quarter of 1989, when t h e market price for Mexican oil s t o o d at $17.25 per barrel, an option to
sell oil five years later at a price of $27 would
have b e e n worth approximately $2.72 ( s e e
T a b l e l). 1 7 This figure is c o m p u t e d using Herb
Johnson and R e n e S t u l z ' s (1987) pricing model,
which is similar to t h e Black-Scholes model but
6
also accounts for default-risk. 1 8 T h e box on page
10 d e s c r i b e s t h e methodology and explains t h e
assumptions and parameter values used.
With a price of $2.72 for an option on o n e
barrel of Mexican oil, a sale of call options on
o n e year's quantity of oil exports could net Mexico $1.28 billion in current r e v e n u e (Table 2). A
s a l e of o p t i o n s on five y e a r s ' e x p o r t s would
bring $6.4 billion. 1 9 This r e v e n u e would b e suffic i e n t to retire 6.37 p e r c e n t of Mexico's foreign
bank d e b t at face value, and m o r e than 15.9 perc e n t at current market discounts. By comparison, t h e recent Mexican financing package negotiated under t h e Brady plan framework extinguished $7 billion in commercial b a n k d e b t .
In addition, a fixed r e d u c e d interest rate was
s e c u r e d on over $22 billion in claims. However,
this d e b t relief was partially offset by new loans
totaling nearly $ 1.4 billion from banks and a b o u t
$5.75 billion from official s o u r c e s to provide for
principal repayments and guarantee interest
( s e e Jorge C. C a s t a ñ e d a 1990 and Truell 1990).
T h e Mexican government has e x p r e s s e d an int e r e s t in further reducing their commercial bank
d e b t over time, and t h e r e v e n u e raised by t h e
proposal p r e s e n t e d h e r e could allow such reductions without a drawdown in reserves.
T h e s a l e of o p t i o n s is not a s a l e of oil; it
merely s e t s t h e highest price that Mexico can
E C O N O M I C R E V I E W , M A R C H / A P R I L 1990
Table 2.
Estimated Revenue to Mexico
For Issues of Options with Various Terms and Strike Prices
(billions of U.S. dollars)
(Based on Johnson-Stulz vulnerable option valuation; assumes options cover 470 million barrels,
approximately one year's exports; all other assumptions are as given in Table 1)
Years until expiration:
Strike price
per barrel
2
3
4
5
6
7
$25
$.60
$.94
$1.20
$1.40
$1.60
$1.70
1.50
1.70
26
.52
.86
1.10
1.40
27
.45
.79
1.10
1.30
1.50
1.60
28
.39
.71
.99
1.20
1.40
1.50
29
.34
.68
.92
1.10
1.30
1.50
.30
.59
.86
1.10
1.30
1.40
31
.26
.54
.79
1.00
1.20
1.40
32
.23
.49
.74
.97
1.20
1.30
30
charge t h e option purchaser for oil during t h e
expiration year. Should t h e price of oil remain
low, Mexico would b e free t o sell oil in any manner it c h o o s e s . Only if t h e price r e b o u n d s and
e x c e e d s t h e $27 strike price would Mexico b e
obliged to sell oil to t h e option holders for $27
per barrel. At that price, though, t h e flow of
revenue would b e sizable, and Mexico's financial situation would b e greatly improved. In
either c a s e , t h e s a l e of covered calls would provide Mexico with a d d e d r e v e n u e now, r e v e n u e
that could b e u s e d to e a s e t h e current financial crisis.
T a b l e l p r e s e n t s t h e Johnson-Stulz prices for
vulnerable Mexican oil options—that is, t h o s e
s u b j e c t to default risk—using various c o m binations of strike prices and maturities. T a b l e 3
p r e s e n t s Black-Scholes prices, which a s s u m e
no d e f a u l t risk b u t c o r r e s p o n d t o t h e s a m e
parameter values. (These p a r a m e t e r s are given
in t h e box and in t h e tables.) T h e difference b e tween the Black-Scholes and johnson-Stulz
prices is t h e credit spread, that is, t h e reduction
in t h e value of t h e option that is d u e to t h e risk of
default. As a p e r c e n t a g e of t h e option price, t h e
credit s p r e a d is lower for higher strike prices.
T h e attractiveness of t h e option is that its c o n tingent liability is paid only when funds are
plentiful and thus effectively d o e s not c o m p e t e
with existing d e b t for available funds.
Mexico is not t h e only e x a m p l e of a country
that could b e n e f i t from selling call o p t i o n s on an
export commodity. Brazil, for example, could
sell options on s o y b e a n s and coffee. Chile and
Peru might sell options on c o p p e r , Bolivia, tin
options. Any commodity-exporting country could
m a k e u s e of a similar strategy. T a b l e 4 lists
several LDC c a n d i d a t e s and t h e i r principal
export commodities.
The Proposal from the
LDCs' Perspective
A s a l e of high strike price covered calls would
p r o v i d e an LDC with m u c h - n e e d e d r e v e n u e
when revenue is otherwise scarce. Unlike a d e b t equity swap—which involves p e r m a n e n t s a l e of
productive resources, often at d e p r e s s e d prices—
t h e LDC covered call entails no loss of control or
ownership over productive resources. S a l e of
LDC c o v e r e d calls, on t h e other hand, relinq u i s h e s only s o m e potential profits for a fixed
a m o u n t of time—that is, t h e difference b e t w e e n
t h e market price of t h e commodity and t h e option's strike price (if t h e difference is positive)
for a p r e s p e c i f i e d quantity of output.
T h e obligation would b e "costly" to t h e LDC
in high-price periods b e c a u s e t h e LDC would
I7
FEDERAL RESERVE B A N K O F ATLANTA
Table 3.
Estimated Value of Default-Free Oil Options
For Various Terms and Strike Prices
(Black-Scholes Pricing Method: Spot Oil Price = $17.25;
Oil Price Volatility = 28 percent per year; Interest Rate = 8 percent per year)
Years until expiration:
Strike price
per barrel
2
3
4
5
6
$25
$1.41
$2.45
$3.47
$4.43
$5.33
$6.18
26
1.23
2.23
3.22
4.17
5.08
5.93
27
1.06
2.02
2.99
3.93
4.83
5.69
28
.92
1.83
2.78
3.71
4.60
5.45
29
.80
1.66
2.58
3.49
4.38
5.23
30
.69
1.51
2.39
3.29
4.18
5.02
31
.60
1.37
2.22
3.11
3.98
4.82
32
.52
1.24
2.07
2.93
3.79
4.63
fulfill its obligation by selling at a lower-thanm a r k e t p r i c e ; however, t h a t p r i c e would b e
much higher than t h e market price had b e e n at
the t i m e t h e option was written. Thus, t h e transaction would still b e profitable to t h e LDC and
would further e n h a n c e its welfare, d e s p i t e its
obligatory nature. Furthermore, if t h e LDC had
u n u s e d p r o d u c t i o n capacity, e x e r c i s e of t h e
o p t i o n s would provide additional customers
and greater total revenue.
Should t h e commodity price not rise a b o v e
t h e strike price, t h e option would expire unexercised and t h e LDC would face no further enc u m b r a n c e . In order to s u p p l e m e n t i n c o m e
during t h e continued low-price state, t h e LDC
might then wish to issue additional covered calls
against another future period's production.
The Proposal from the
Creditor's Perspective
S a l e s of c o v e r e d calls by LDCs would b e n e f i t
creditors for several reasons. T h e new instrum e n t e m b o d i e s s o m e attractive i n v e s t m e n t
features. LDCs' selling covered calls r e p r e s e n t s
a f e a s i b l e alternative to d e m a n d i n g new loans
from creditors. T h e r e v e n u e covered calls provide LDCs would e n h a n c e t h e val ue of t h e other
8
7
LDC d e b t held by t h e creditors. Although cove r e d calls require no servicing prior to expiration, unlike d e b t forgiveness, they have inherent
value; thus t h e accounting t r e a t m e n t is m o r e
favorable to banks than is outright d e b t forgiveness.
A n o t h e r a d v a n t a g e o u s f e a t u r e of an LDC
covered call is its ability to let t h e investor/
creditor share m o r e fully in t h e fortunes of t h e
LDC during t i m e s of increasing c o m m o d i t y
prices. A portfol io of loans to an LDC carries cons i d e r a b l e e x p o s u r e to commodity price risk, but
offers limited reward should prices rise. LDC
covered calls would grant creditors a c c e s s t o
g r e a t e r u p s i d e p o t e n t i a l . Just a s c o m m o d i t y
prices are theoretically u n b o u n d e d , t h e p o t e n tial gain from owning an LDC covered call would
b e unlimited.
Although t h e option would expire worthless
should commodity prices not recover, t h e s a m e
could b e said of LDC d e b t . Nonperformance on
loans is q u i t e p o s s i b l e during t h e low-price
p e r i o d s in which an option would expire out of
t h e money. Thus, LDC d e b t and LDC covered
calls have certain downside features in c o m mon. Certainly t h e r e a r e p r i c e s c e n a r i o s in
which LDC d e b t would perform b e t t e r than LDC
c o v e r e d calls; n e v e r t h e l e s s , s o m e c r e d i t o r s /
investors might prefer t h e different risk-return
profile of t h e option.
E C O N O M I C R E V I E W , M A R C H / A P R I L 1990
Another potentially attractive feature of LDC
covered calls could b e their greater liquidity
relative to LDC bank d e b t and equity stakes. As
a standardized security, LDC covered calls
should b e easier to sell than bank d e b t and
equity holdings. Indeed, an active market for
LDC covered calls might develop in response to
their availability. Banks would then have an
avenue to reduce their LDC exposure, should
they wish to, by swapping bank d e b t for calls
and then selling those calls in the market.
The proposal should also appeal to creditors
b e c a u s e of the effect it would have on the entire
portfolio of LDC investments. The options would
only pay off when LDC funds are plentiful, and
the initial sale or swap of the options would
reduce the LDC's d e b t burden. Hence, the LDC
could better service all of its obligations regardless of the behavior of commodity prices. The
LDC would potentially have more funds for development and thus face enhanced future financial prospects. Accordingly, the value of all the
LDC's outstanding d e b t could appreciate.
Clearly, purchase of LDC covered calls is preferable to d e b t forgiveness from the creditors'
point of view. Like d e b t forgiveness, selling LDC
covered calls would relieve the debtor of s o m e
d e b t service obligations and make service of
remaining d e b t more manageable. This change
would enhance the value of remaining debt, just
as d e b t forgiveness d o e s . By receiving LDC
covered calls, however, creditors would maintain a claim on LDC funds that might b e c o m e
available at a later date. Furthermore, whereas
banks must write off d e b t that is forgiven, receipt of calls would preserve s o m e capital since
LDC covered calls are a valuable asset.
The Market for LDC Covered Calls
Users of the LDC's export commodity face
price risk exactly opposite of that borne by the
LDC: users suffer when prices are high and prosper when prices are low. Purchase of an LDC
c o v e r e d call would b e a form of insurance
against excessive price hikes. It would insulate
the user against severe fluctuations in the commodity price, thereby facilitating investment
planning and marketing decisions. Should the
price remain low, the option would expire
Table 4.
Selected Heavily Indebted
Countries and Their Chief
Export Commodities
Export Revenue
from Commodity
as a Percent
of Total Exports,
1982-88
Country
Commodity
Argentina
Wheat
Corn
10.8
7.8
Bolivia
Natural Gas
Tin
49.3
25.1
Brazil
Soybeans
Coffee
Chile
Copper
45.4
Colombia
Coffee
Fuel Oil
39.8
13.4
Ecuador
Crude Oil
Bananas
54.7
9.4
Côte d'Ivoire
Cocoa Beans
Coffee
29.7
18.3
Mexico
Petroleum
57.0
Morocco
Phosphates
18.5
Peru
Copper
Zinc
16.8
9.5
Philippines
Coconut Products
10.8
Uruguay
Wool
19.7
Venezuela
Petroleum
86.0
9.5
8.4
Source: International M o n e t a r y Fund.
worthless, much in the s a m e way an accident
insurance policy returns nothing when no accident occurs. During low-price periods, however,
the option owner would continue to enjoy the
low price of the essential commodity.
Processors and distributors of oil products,
along with the U.S. Department of Energy, which
purchases oil to supply the nation's strategic
reserves, might b e potential buyers of LDC
covered calls on oil. Agents who wish to speculate on the price of oil might also b e interested,
and they would add liquidity to the market.
Investment managers could u s e LDC covered
calls to hedge over the long term against the
adverse effects commodity price shocks can
I7
FEDERAL RESERVE BANK OF ATLANTA
exert on investment portfolios. Currently, few
instruments are available that allow a g e n t s to
s p e c u l a t e or h e d g e prices over t h e long term.
Potential Problems
This plan is s u b j e c t to criticism in several
a r e a s , and certain d e t a i l s would have t o b e
worked out. For example, creditors and investors might fear that an LDC would r e n e g e on its
obligation should t h e price of oil rise substantially a b o v e t h e option strike price. This b e havior is unlikely, however, s i n c e it would b e
akin to default on a loan. An LDC's initial s a l e of
LDC covered calls in order t o retire d e b t would
exhibit a willingness to honor international financial a g r e e m e n t s . For countries striving t o d o
s o during hard times, reneging during e a s i e r circ u m s t a n c e s s e e m s unlikely.
T h e LDC would have to b e a r inflation risk.
Worldwide inflation over t h e life of t h e option
might lower t h e real value of t h e strike price at
which t h e commodity would have to b e sold. If
this occurred, however, t h e s a m e inflation that
would m a k e fulfillment of t h e option obligation
costl ier to t h e LDC would also rel ieve t h e LDC of
s o m e of its d e b t burden. Inflation i n c r e a s e s t h e
real c o s t of t h e option obligation but d e c r e a s e s
the real cost of t h e d e b t obligations. As long a s
the term of t h e options were similar to or shorter
than t h e interval at which banks reprice loans in
r e s p o n s e to inflation a n d changing i n t e r e s t
rates, t h e two countervailing inflation effects
c o u l d o f f s e t o n e a n o t h e r . In this way, LDC
covered calls could possibly offer creditors and
d e b t o r s a h e d g e against inflation risk.
Logistical details n e e d to b e a d d r e s s e d on a
c a s e - b y - c a s e basis. For instance, to avoid simultaneous e x e r c i s e of all options, which would
put a t r e m e n d o u s strain on t h e LDC's ability to
deliver t h e commodity, t h e option could b e
written s o that a forward delivery contract would
b e sold to t h e holder, with t h e delivery d a t e
d e t e r m i n e d by t h e order in which t h e e x e r c i s e
r e q u e s t is received.
Conclusions
High strike price covered call o p t i o n s are a
market-oriented solution that should b e explored further and given serious consideration
as a r e s p o n s e to t h e current LDC d e b t crisis.
B e c a u s e their u s e offers LDCs a new source of
revenue without adding to an already difficult
d e b t burden, sale of call o p t i o n s would b e n e f i t
both LDCs and t h e holders of existing LDC d e b t .
By smoothing income across p e r i o d s of high and
low commodity prices and providing insurance
against periods of excessively high commodity
prices, this financial instrument holds advant a g e s for LDCs, c o n s u m e r s of their export c o m m o d i t i e s , and investors. Thus, it p r e s e n t s a
promising new approach to easing d e b t obligations and furthering e c o n o m i c a d v a n c e m e n t in
highly i n d e b t e d countries.
An Explanation of t h e Johnson-Stulz Pricing Model
The Johnson-Stulz method is useful for valuing
"vulnerable" options, that is, options that face
some risk of default. The method relies on various
assumptions similar to those required by the
Black-Scholes methodology, which is commonly
used to price exchange-traded and other defaultfree options. Both models assume that the price of
the underlying asset (oil in the Mexican example)
moves randomly and smoothly through time and
that the percent change over any instant of time is
independent of the change at any other point in
10
time. 1 Therefore, the intrinsic value of the optionthat is, the difference between the strike price and
the underlying asset price—also moves smoothly.
Black and Scholes showed that a portfolio consisting of the underlying asset and a short position in
bonds could exactly replicate the option. Because
the replicating portfolio and actual option offer
the same payoff at expiration, theirvalues must be
the same any time before expiration. Otherwise,
arbitrage profits could be realized. The BlackScholes methodology essentially prices the op-
E C O N O M I C R E V I E W , M A R C H / A P R I L 1990
tion by adding up the observable prices of the
assets in the replicating portfolio.
The Johnson-Stulz method differs from the
Black-Scholes method in that it assumes the
option writer has limited assets available to meet
the potential liability of the option. Mexico, for
example, has a limited pool of funds with which to
cover its option obligations upon exercise. If the
pool value falls below the option obligation, the
option owners do not receive the full option payoff
upon expiration. 2 Instead, they receive the available funds in the pool. In other words, at expiration the vulnerable call pays the minimum of the
option's intrinsic value or its share of the pool (the
total pool divided by the number of options
issued).
In pricing the option used in the example, the
pool was valued in the following manner: for a
given period, Mexico's current account surplus,
which was sometimes negative, was added to the
previous period's foreign currency reserves, and
required debt service was subtracted. 3 This number, however, was often negative since Mexico partially financed large trade deficits and debt service
by obtaining new loans. To apply the JohnsonStulz method, it was necessary to adjust the pool,
normalizing it to equal zero at the level at which
default would b e likely.
The unadjusted pool reached its historical
minimum in the third quarter of 1981; the next
year Mexico suspended interest payments. Since
that time the total quantity of foreign debt has
risen. Moreover, both the ratio of debt service to
GNP and the ratio of external liabilities to GNP
have similarly been much higher in several of the
years since the time of the payments moratorium.4
Thus, the rapid rate of capital outflow, rather than
the excessive level of debt amassed, apparently
was the main factor prompting Mexico's interest
suspension in 1982. To normalize the pool, therefore, it was assumed that Mexico would make payments on the options as long as the pool value
remained above its historical minimum. If that
minimum were ever again achieved, it would lead
to default. To normalize the pool in this way, the
historical minimum ( - $ 5 . 4 billion) was subtracted
from each entry in the time series of pool values. 5
Finally, the pool per option was computed by
dividing the total pool value by the number of
options issued.
Table I presents Johnson-Stulz prices for Mexican oil options using various combinations of
strike prices and maturities. The computation
uses data from the second quarter of 1989. The oil
price was $17.25 per barrel at that time. The total
value of the pool was $5.1 billion, or $10.77 per
option if options are issued on one full year's
worth of exports, 470 million barrels. Parameter
inputs were estimated using quarterly data from
1982 to 1989. The standard deviation of percent
changes in the pool value is 43 percent per year.
The volatility of the oil price is 28 percent per
year.
The prices in Table 1 may overstate the true
value of these options for the following reason: the
oil price may not follow a random walk as the
Johnson-Stulz, like the Black-Scholes, model assumes. Oil prices may revert to some long-run
level, which may vary over time. If this were true,
the oil prices would not be as variable overtime as
the models predict, and so the computed prices
would b e too high. However, there is no firm
empirical evidence that oil prices are meanreverting. Nevertheless, the Johnson-Stulz prices,
though possibly high, are closer to the true value
of the default-risky options than the Black-Scholes
prices. Further modeling research should achieve
more reliable values for these options.
The Johnson-Stulz methodology takes into account the relationship between the value of the
pool and the underlying commodity. When oil
prices are high, the funds available to Mexico to
service outstanding debt and pay off options are
more plentiful. The correlation coefficient between these two variables is 0.5, estimated over
the sample period running from 1982 to 1989. The
higher this correlation, the lower the option default risk will be. A high positive correlation would
be expected for countries like Mexico whose
economies depend largely on single export commodities. Thus, high strike price covered call
options are attractive instruments for these countries, since the relationship between commodity
price and the country's financial resources mitigates default.
Notes
'More precisely, the asset price is assumed t o follow a
diffusion process (a continuous-time geometric Brownian motion). This assumption is standard in o p t i o n
pricing models. For t h e sake of greater realism, it
would be desirable to allow discrete jumps in the process, which, for example, might be due to oil price
I7
FEDERAL RESERVE BANK O F ATLANTA
shocks. However, such a model poses serious technical problems in valuing vulnerable options. These
details will be addressed in future research.
2
Since Mexico would own the oil on which the option
was written, however, a default on the options would
entail selling the oil to a third party on the spot market
rather than selling to the option owner at the strike
price.
3
Data were provided by the International Monetary
Fund and Banco d e Mexico.
4
The Economist Intelligence Unit (19891, 35.
5
Since this computation involved subtracting a negative number, it in effect a d d e d to the pool. This
recognizes the historical record that the unadjusted
pool could become negative without resulting in a
default.
Notes
'The type of option proposed here is the "European"
option, which cannot be exercised until maturity.
2
E. Schwartz (1982) cited two instances where commoditylinked bonds—which grant the lender the option to take a
given quantity of a commodity instead of the principal at
maturity—had been issued. O'Hara (forthcoming) described how commodity-linked bonds could be used to
shift c o m m o d i t y price risk from LDCs to risk-neutral
banks. Many other examples exist.
The "value recovery clause" in the recent Mexican d e b t
package allows banks to receive additional payments
starting in 1996 should the price of oil b e above $14 per
barrel in constant 1989 dollars by that time. The additional
payments will be subject to a cap proportional to the
amount of old loans each bank tenders in exchange for the
new fixed-interest bonds.
^The World Bank (1989a), 2.
4
LIBOR is the rate of interest on large loans between creditworthy international banks. It is commonly used as the
base rate for floating-rate international loans, much in the
manner that the prime rate is often used as the base for
floating rates on loans in the United States.
^The World Bank (1988), xi.
^See Schuker (1988), 134.
7
lbid.
d e v e l o p i n g countries amassed current account surpluses
totalling $11.9 billion (U.S.) over the five years from 1971
through 1975. Over the period 1981-86, LDCs amassed
deficits totaling $242.7 b i l l i o n (International Monetary
Fund, 1987 Yearbook, 136).
9
See Schuker (1988), 134.
l0
Latin America's per capita output fell 7 percent in the
1980s, whereas it had grown 40 percent in the 1970s. See
Farnsworth (1990).
1
'See "LDC Debt News" (1990), 12.
l2
See Sachs (1989b), 92, and DiLeo and Remolona (1989).
13
In practice, it would not be necessary to issue two options;
one contingent claim contract can be written with the
same features.
'"See "Country Risk-Watch," (1989/90), 94-95.
,5
The World Bank (1989b), 254.
l6
See Banco d e Mexico.
l7
World Oil Price Table, Weekly Petroleum Status Report.
l8
For a description of the Black-Scholes model, see Black
and Scholes (1973).
19
This is the sum of the val ues of five series of options covering export production for the period between three and
seven years into the future. Three-year options would
cover the oil to be produced three years from now, fouryear options would cover production four years from now,
and so forth.
References
Banco d e Mexico. "Indicadores del Sector Externo." Indicadores Economicos, updated monthly.
Black, Fischer, and Myron Scholes. "The Pricing of Options
and Corporate Liabilities." journal of Political Economy
81 (1973): 637-59.
Castañeda, )orgeC. "Mexico's Dismal Debt Deal." New York
Times, February 25, 1990.
"Country Risk-Watch " The International Economy 3 (December 1989/)anuary 1990): 94-95.
DiLeo, Paul, and Eli M. Remolona. "On Voluntary Conversions of LDC Debt." Federal Reserve Bank of New York,
unpublished manuscript, July 24, 1989.
Dornbusch, Rudiger. "International Debt and Economic
Instability." Federal Reserve Bank of Kansas City Economic Review (January 1987): 15-32.
12
Durr, Barbara. "Debt, Inflation Continue to Hamper Latin
America." Financial Times, December 22, 1989.
The Economist Intelligence Unit. Mexico: Country Profile,
1989-90. Annual Survey of Political and Economic Background. London: The Economist Intelligence United
Limited, 1989.
Farnsworth, Clyde. "U.S. Falls Short on Its Debt Plan for Third
World." New York Times, January 9, 1990.
International Monetary Fund. International Financial Statistics. Washington, D.C.: IMF, various issues.
Johnson, Herb, and René Stulz. "The Pricing of Options with
Default Risk." Journal of Finance 42 (June 1987): 267-80.
"LDC Debt News." American Banker, March 20, 1990, 12.
O'Hara, Maureen. "Financial Contracts and International
Lending." Journal of Banking and Finance (forthcoming).
E C O N O M I C R E V I E W , M A R C H / A P R I L 1990
Perasso, Giancarlo. "The Pricing of LDC Debt in the Secondary Market: An Empirical Analysis." Kyklos 42, fasc. 4
(1989): 533-55.
Sachs, leffrey. "New Approaches to the Latin American Debt
Crisis." Essays in International Finance, no. 174. International Finance Section, Department of Economics,
Princeton University. Princeton, New Jersey, July 1989a.
. "Making the Brady Plan Work." Foreign Affairs
(September 1989b): 87-104.
Schuker, Stephen A. American "Reparations" to Germany,
1919-33: Implications for the Third-World Debt Crisis.
Princeton Studies in International Finance, no. 61. International Finance Section, Department of Economics,
Princeton University. Princeton, New Jersey, July 1988.
Schwartz, Eduardo. "The Pricing of C o m m o d i t y Linked
Bonds." Journal of Finance 37, no. 2 (1982): 525-39.
Truell, Peter. "Mexico, Creditor Banks Complete Pact Covering $48 Billion of Debt." Wall Street Journal, January 11,
1990.
The World Bank. World Debt Tables, 1987-88: External Debt
of Devloping Countries. Vol. I, Analysis and Summary
Tables. Washington, D.C., 1988.
. World Debt Tables, 1989-90: External Debt of
Developing Countries. Vol. I, Analysis and Summary
Tables. Washington, D.C., 1989a.
. World Debt Tables, 1989-90: External Debt of
Developing Countries. Vol. 2, Country Tables. Washington, DC., 1989b.
Schwartz, Anna J. "International Debts: What's Fact and
What's Fiction." Economic Inquiry 27 (January 1989): 1-19.
I7
FEDERAL RESERVE BANK O F ATLANTA
Determinants of
De Novo Bank Performance
William C. Hunter and Aruna Srinivasan
This study expands the focus of previous research on the performance of newly chartered banks. The authors'
methodology not only identifies the determinants of financial success hut also ranks these factors in terms of their
relative importance. The research sample consists of 169 independent de novo banks chartered in 1980 and still
operating as independent organizations in 1988. By gauging new banks' performance as compared with that of
similar, established banks in the same state of charter, this study avoids possible biases due to differences in
regional economies.
dentifying the characteristics that make a
financial institution successful has b e c o m e a significant consideration, e s p e cially given the failure of record n u m b e r s of
banks and savings and loan institutions during
the past d e c a d e . While much attention has
b e e n directed toward pinpointing the causes of
financial distress in e s t a b l i s h e d institutions,
analysts are focusing increasingly on determining the factors that lead to success in newly chartered financial institutions. By understanding
the e l e m e n t s that contribute to soundness in
d e novo banks, regulators and management, as
I
The authors are, respectively, a research officer and an
economist in the financial section of the research department at the Federal Reserve Bank of Atlanta. They thank Rob
McDonough and Willy Wolfe for excellent research assistance.
14
well as depositors and other investors, may b e
a b l e to identify problems in time to react judiciously. Bank chartering agencies, too, s e e k a
better understanding of the economics of startup banking operations in today's less regulated
environment. This knowledge would aid in prescribing appropriate criteria for the charter application review and approval process.
This article investigates the financial performance of independent d e novo banks chartered in 1980 and still surviving in 1988. The
study compares earnings of t h e s e institutions,
which were drawn from a national sample, in
their first, third, fifth, and eighth years of operation with those of similarly situated, established
banks during the s a m e calendar years. A d e
novo bank is considered financially successful if
its earnings, measured by the return on assets
(ROA), are at least 80 percent of the m e d ian ROA
for established banks with less than $100 milE C O N O M I C R E V I E W , M A R C H / A P R I L 1990
lion in a s s e t s in t h e s a m p l e bank's s t a t e of
charter.
This study develops a statistical model of the
surviving banks' financial performance in 1981,
1983, 1985, and 1988 to identify and analyze
several factors that are crucial in determining
the probability of financial success. 1 This analysis reveals that only a small s u b s e t of the factors
typically cited as key influences on d e novo
banks' survival plays a systematic role during
the start-up phase of operations. Specifically,
the study identifies the primary determinants of
newly chartered banks' financial s u c c e s s as:
(1) the overall quality of the bank's credit policies, exemplified by its procedures for credit
evaluation and approval as well as loan monitoring and collection; (2) the bank's ability to control operating costs such as wages and salaries;
and (3) the bank's level of capitalization at startup. Factors such as market structure and economic conditions in the bank's local trade area,
while important in a generic sense, do not exert
much impact on the probability of financial succ e s s when considered independently.
A Previous Study of
De Novo Bank Performance
Though a number of studies have examined
the performance of d e novo commercial banks,
research by Nasser Arshadi and Edward C. Lawrence (1987) is most relevant to the analysis presented in this article. 2 Arshadi and Lawrence
studied the financial performance of 438 banks
chartered between 1977 and 1979 in their third
and fifth years of operation, using canonical correlation analysis, a statistical technique useful
for determining the maximum correlation b e tween two sets of variables. T h e two researchers
examined variables both internal and external
to banks' decision making in relation to several
gauges of performance: the return on assets, the
ratio of interest and f e e s on loans to total loans,
and the bank's share of the total loans in the
primary trade area. Endogenous factors included
indicators of b a n k c o s t such as t h e ratio of
salaries and wages to total assets, loan portfolio
composition (the proportion of the portfolio
invested in consumer, real estate, commercial,
and industrial loans), the return on the loan
portfolio, and deposit composition. Among the
exogenous factors studied were indicators of
market structure, such as the number of competing banks, as well as economic and demographic conditions in the primary trade area—for
example, growth in effective buying income and
population per banking office.
Based on their empirical analysis, Arshadi
and Lawrence concluded that the performance
of newly chartered banks d e p e n d s most critically on endogenous factors such as cost structure, a s s e t size, and t h e c o m p o s i t i o n of the
loan portfolio. A notable finding of their study
was the relatively minor influence on performance exerted by market structure and economic conditions in the bank's trade area.
While Arshadi and Lawrence's results are
interesting, the limitations of their methodology, canonical correlation analysis, precluded explicit calculation of the marginal value or impact
of bank-specific and market characteristics on a
d e novo bank's chances of financial success.
Their analysis therefore could not rank the factors in terms of their relative importance. In
addition, b e c a u s e Arshadi and Lawrence analyzed s a m p l e banks' a b s o l u t e performance
rather than performance relative to similarly
situated banks, regional factors such as t h e
state of the oil industry in the Southwest or the
farm economy in the Midwest may have biased
their conclusions.
Research Methodology and
Variable Definitions
In contrast to Arshadi and Lawrence's study,
the explicit goals of the analysis in this article
are to characterize the marginal impact of bankspecific attributes on the probability that a d e
novo bank will b e financially successful and to
determine whether exogenous market and regulatory factors play a significant role in determining success. By paying particular attention to the
financial performance of each sample bank relative to the performance of similar banks in the
sample bank's state of charter, this study avoids
possible biases due to differences in regional
economies.
The Performance Measure and Statistical
Model. For the purposes of this study, a bank
I7
F E D E R A L RESERVE B A N K O F ATLANTA
was d e e m e d financially successful if its return
on assets (ROA) was equal to or greater than 80
percent of the median ROA for banks in the
state of charter with total assets less than $100
million. Similarly, a bank was identified as unsuccessful if its ROA was less than 80 percent of
the median ROA for banks in the comparison
group. A binary (indicator) variable was assigned
for each sample bank and was s e t equal to a
value of one if the bank was classified as financially successful and zero if the bank was considered unsuccessful.
The binary variable, which d e n o t e s the occurrence or nonoccurrence of the event "financial success," was developed to allow the use of
probit analysis, a technique that estimates the
impact of observable characteristics on the probability of an event's occurring. For a detailed
description of the probit technique s e e the box
on page 23. 3 In this study, the probit technique
permitted the determination of bank-specific
and market or regulatory factors' marginal impact on the probability that a bank's financial
performance will b e classified as successful. 4
For each year of analysis, the following probit
model describing financial success was estimated:
Sj = a + fix
+
ei,
where S(- is the performance indicator variable
for bank /', /3 is a vector of parameters to b e
estimated, X is a vector of bank-specific attrib u t e s and exogenous market and regulatory factors, and e,- is an error term. The model was
estimated for 1981, 1983, 1985, and 1988, when
the sample banks were one, three, five, and
eight years old, respectively. T h e s e years are
consistent with bank chartering agencies' practice of examining d e novo banks within three to
five years after granting their charters.
study is that the probability of financial success
will b e inversely related to the variables SALARIES (the ratio of wage and salary e x p e n s e s to
total assets) and LTIMEDEP (the ratio of large
time deposits to total deposits). Holding other
factors constant, increases in personnel exp e n s e s imply lower bank profitability and a
reduced ROA. Likewise, the larger the proportion of deposits on which a bank pays interest
rates that are highly competitive, the lower its
profit margin should be. On the other hand,
ceteris paribus gains in the variable NOWACC
(the ratio of NOW accounts and other savings
accounts subject to interest rate ceilings to total
deposits) would b e expected to increase the
probability of financial success since this serves
as a proxy for the bank's level of core deposits
(that is, t h e bank's lowest-cost, most s t a b l e
deposits). Lower funding costs should improve
the bank's profitability, raising the ROA.
The logic of the relationship between a bank's
cushion of capital and its financial performance
is also essentially straightforward. Typically, the
better capitalized a d e novo commercial bank
is, the better its chances for survival. Equity
capital acts as a buffer against the unforeseen
losses incurred by all banks; it is critical to newly
chartered banks' probability of survival. This
study assumes that if all other factors remain
constant, increases in a bank's ratio of total capital to total assets (CAPITAL) will increase its
probability of financial success. 7
Variable Definitions. The specific bank attributes and exogenous factors included as components of t h e X v e c t o r in the probit model were
s e l e c t e d to represent the following eight areas:
bank operating cost structure, leverage, loan
portfolio composition, credit policy, liquidity,
local market structure, state branching law, and
the economic climate of the local trade area. 5
The specific variables included in each category
are defined in Table l. 6
T h e relationship between the probability of
financial s u c c e s s and the composition of a
bank's loan portfolio is harder to characterize.
Ordinarily, the more diversified its loan portfolio, the more likely the bank is to avoid significant l o s s e s resulting from concentrating its
lending in an area or industry which unforeseen
e v e n t s may adversely affect. N o n e t h e l e s s , a
bank may concentrate its lending in few sectors
and remain quite profitable if it has a d e q u a t e
credit evaluation, monitoring, and collection
policies. Many banks' credit policy standards
also specify the types of loans to b e made and
their proportions of the total portfolio. In t h e s e
c a s e s the relationship between loan portfolio
composition and the probability of success dep e n d s critically on the quality of t h e bank's
credit policies.
With respect to the variables measuring bank
cost structure, the a priori expectation in this
A bank's credit policy is generally considered
a key determinant of its long-run survival prob-
16
E C O N O M I C R E V I E W , M A R C H / A P R I L 1990
Table 1.
Variable Definitions
Performance Measure:
= 1, if ROA > 8 0 percent of median ROA of target group 3
0, otherwise
S
Cost Structure:
SALARIES
LTIMEDEP
NOWACC
= ratio of wage and salary expenses to total assets
= ratio of large time deposits to total deposits
= ratio of NOW accounts and other savings accounts subject to
interest rate ceilings to total deposits
Loan Portfolio Composition:
REALEST
CONS
C&l
= ratio of real estate loans to total loans
= ratio of consumer loans to total loans
= ratio of commerical and industrial loans to total loans
Credit Policy:
LOANLOSS = ratio of charge-offs net of recoveries to total loans
Liquidity:
FEDFUNDS = ratio of net federal funds purchased to total deposits
LOANDEP = ratio of total loans to total deposits
Leverage:
CAPITAL
= ratio of total equity capital to total assets
Market Structure:
MSA
= 1, if the bank is chartered in a metropolitan statistical area (MSA)
0, otherwise
= concentration ratio of three largest firms in the local market
3FIRMCR
Regulatory Structure:
STATEBR
= 1,
0,
= 1,
0,
LTDBR
if bank is chartered in statewide branching state
otherwise
if bank is chartered in limited branching state
otherwise
Economic Conditions:
CHGPI
a
The target group is composed
= change in personal income growth in the local market
of all banks in the state of charter with total assets less than $100
ability. As n o t e d a b o v e , t h r e e primary comp o n e n t s of a bank's credit policy are its credit
evaluation p r o c e d u r e s and standards, monitoring policy, and collection procedures. T h e varia b l e LOANLOSS r e p r e s e n t s t h e effectiveness of
t h e credit policy. Clearly, this policy will control
t h e quality of t h e loan portfolio, which, in turn,
will d e t e r m i n e t h e bank's net l o s s e s and, hence,
its e c o n o m i c viability. Thus, in t h e a b s e n c e of
other changes, increases in t h e bank's ratio of
net charge-offs to total loans should d e c r e a s e
profitability a n d t h e p r o b a b i l i t y of financial
success.
Making e x a n t e predictions a b o u t t h e impact
of t h e variables measuring s a m p l e b a n k liquidFEDERAL RESERVE B A N K O F ATLANTA
million.
ity ( F E D F U N D S a n d LOANDEP) on a b a n k ' s
probability of s u c c e s s is problematic without
d e t a i l e d knowledge of t h e bank's credit policy
and its loan d e m a n d . T h e s a m p l e banks are net
s e l l e r s of federal funds in all years. This transaction is essentially a short-term loan by o n e b a n k
to another, which is borrowing to m e e t its reserve r e q u i r e m e n t s or loan d e m a n d . A d e c r e a s e
in t h e FEDFUNDS variable (the variable b e c o m e s m o r e negative) could b e taken a s a signal
that t h e b a n k has additional temporary e x c e s s
liquidity and is investing in this market short
term ; a d e c r e a s e could b e interpreted to mean,
however, that t h e bank is refusing to m a k e additional loans or hold m o r e securities. Although
I 7
t h e latter explanations might suggest that t h e
b a n k is being t o o conservative or turning down
legitimate loan r e q u e s t s , such a conclusion is
not warranted without an understanding of t h e
bank's loan policies and loan d e m a n d . In t h e
s a m e m a n n e r c e t e r i s p a r i b u s i n c r e a s e s in a
bank's l o a n - t o - d e p o s i t ratio, LOANDEP, could
e n h a n c e or detract from t h e bank's profitability
under various loan-quality scenarios.
Like portfolio composition, s o m e environmental variables could influence financial performance in o p p o s i t e ways. For example, it is
difficult to specify t h e ex a n t e effect of a d e novo
bank's l o c a t i o n — r e p e s e n t e d by t h e MSA (metropolitan statistical area) variable—on t h e probability of success. Such factors as t h e bank's
credit policy and t h e nature of c o m p e t i t i o n in
t h e bank's primary area will greatly affect t h e
MSA variable's impact.
I n d e p e n d e n t of its location, and holding
other factors equal, a newly chartered b a n k will
b e l e s s likely to p r o s p e r during t h e start-up
p h a s e t h e m o r e c o n c e n t r a t e d t h e primary trade
area or local market is (the higher t h e variable
3F1RMCR). 8 To t h e e x t e n t that t h e m a r k e t is
d o m i n a t e d by b a n k s with strong c u s t o m e r
relationships—and, h e n c e , significant market
shares—the new b a n k will b e forced to c o m p e t e
on t h e b a s i s of rates on loans and d e p o s i t s a s
well as other services whose provision entails
additional operating costs without any guarant e e of increased revenues. Alternatively, b a n k s
in c o n c e n t r a t e d markets may earn high profits
without having to offer competitive prices. T h e s e
profits should provide a protective umbrella for
new entrants.
S t a t e branching laws can play an important
role in determining t h e long-run financial succ e s s of newly chartered banks. Although branching is a proven m e t h o d by which banks can grow
and diversify their retail d e p o s i t and loan portfolios, b r a n c h i n g a l s o allows c o m p e t i t o r s t o
e n t e r a bank's trade area. Thus, relative to t h e
c a s e of unit banking laws, t h e effect of statewide
and limited branching laws on t h e probability of
financial s u c c e s s could b e either positive or
negative.
General e c o n o m i c conditions in t h e s a m p l e
banks' primary trade areas are m e a s u r e d by t h e
variable CHGPI, t h e c h a n g e in personal income
growth in t h e local market. Clearly, ceteris parib u s increases in this variable should improve
18
d e novo b a n k s ' p r o b a b i l i t y of financial success.9
D a t a a n d S a m p l e Selection. T h e full s a m p l e
consists of 169 i n d e p e n d e n t b a n k s chartered in
1980 in 32 states. New i n d e p e n d e n t banks warrant distinct scrutiny b e c a u s e r e c e n t e v i d e n c e
(John R o s e and Donald Savage 1984) indicates
that their performance differs from that of new
b a n k s f o r m e d a s s u b s i d i a r i e s of m u l t i b a n k
holding c o m p a n i e s . As did earlier studies, this
research excludes industrial banks, trust c o m panies, " p h a n t o m " banks organized to facilitate
acquisition of an ongoing bank, and b a n k s organized by foreign banking organizations.
T h e year 1980 was s e l e c t e d a s t h e starting
point for two reasons. First, t h e Office of t h e
Comptroller of t h e Currency (OCC), t h e principal
regulator of national banks, liberalized its policy
for granting national b a n k charters in that year.
T h e OCC also a d o p t e d a new weighting s c h e m e
which p l a c e d greater e m p h a s i s on t h e agency's
" a p p r a i s a l of t h e organizing g r o u p a n d its
operating plan for establishing and operating a
b a n k " and less e m p h a s i s on " t h e community's
e c o n o m i c and c o m p e t i t i v e characteristics." T h e
revised policy reflected t h e OCC's e x p e r i e n c e
that " a strong organizing group . . . |was] generally a b l e t o establish and o p e r a t e a successful
b a n k even in t h e most economically d i s t r e s s e d
or m o s t highly c o m p e t i t i v e markets." S e c o n d ,
using 1980 a s t h e b a s e year p e r m i t t e d t h e
examination of d e novo banks during a period in
which b a n k regulation was b e i n g liberalized.
This focus is especially significant since little is
known a b o u t t h e effect of interest-rate, product,
and geographic market deregulation on new
b a n k performance.
Of t h e s a m p l e b a n k s o p e n e d in 1980, 67 perc e n t were located in metropolitan areas (MSAs),
and 123 of t h e 169 b a n k s had s t a t e charters. By
t h e e n d of 1988, only 96 of t h e original 169 banks
were still operating independently. Seventyt h r e e b a n k s had either failed or m e r g e d with
other financial institutions, including multibank
holding c o m p a n i e s .
T h e financial and regulatory data on each
s a m p l e bank were taken from t h e Reports of
Condition and Reports of Income filed annually
with t h e Federal Reserve System. T h e data on
personal income were gathered from various
issues of t h e U.S. C o m m e r c e Department's Survey of Current
Business..
E C O N O M I C R E V I E W , M A R C H / A P R I L 1990
Table 2.
Means of Variables for Different Years
1981
Variable 3
(Age
1
)
1983
(Age 3)
1985
(Age 5)
1988
(Age 8)
SALARIES
0.02
0.02
0.02
0.02
LTIMEDEP
0.31
0.24
0.21
0.17
NOWACC
0.06
0.05
NA
NA
0.35
0.47
REALEST
0.22
0.29
CONS
0.30
0.28
0.25
0.21
C&l
0.41
0.38
0.34
0.28
LOANLOSS
0.00
0.01
0.02
0.02
-0.07
-0.08
-0.10
-0.04
LOANDEP
0.66
0.66
0.67
0.65
CAPITAL
0.15
0.10
0.07
0.07
MEAN ROA
(Percent)
1.06
0.12
-0.44
0.37
MEDIAN ROA
(Percent)
1.28
0.48
0.39
0.70
MEAN ROE
(Percent)
6.37
0.42
-11.81
1.43
MEDIAN ROE
(Percent)
7.53
4.38
4.45
9.28
165
141
123
96
FEDFUNDS
Number of
Surviving Banks
a
See Table 1 for variable
NA = Not applicable
definitions.
in the indicated
years.
The Empirical Findings
The mean values of each of the continuous
variables included in the analysis are given in
Table 2 for 1981, the first full year of operation for
the sample banks, and for 1983, 1985, and 1988,
along with the median and mean ROA of the surviving banks. T h e mean ROA of the s a m p l e
banks was a very favorable 1.06 percent for 1981,
the first full year of operation. However, the ratio
returned to more normal levels (less than 1 percent) as the surviving sample banks b e c a m e
more established.
Table 3 profiles the performance of the sample banks by age, showing the number and perc e n t a g e of t h e surviving s a m p l e b a n k s with
ROAs greater than zero, greater than or equal to
80 percent of the median ROA of established
banks with total assets not exceeding $100 million in the relevant state of charter, and greater
than or equal to 150 percent of the median ROA
of the established banks. Since the majority of
the sample banks were chartered in late 1980,
the zero age category typically represents operating performance over only one or two months.
About 86 percent of the sample banks surviving
for at least one year posted positive net income
in the first year of operation ; about 26 percent of
the sample banks at that age demonstrated
earnings superior to t h o s e of their established
counterparts—that is, their ROA indices were
150 percent or more of the median of their more
established counterparts. 1 0
I7
FEDERAL RESERVE BANK O F ATLANTA
Table 3.
De Novo Bank Earnings Performance by Age, 1980-88
Break-Even
Analysis
Age
Number of Banks
Earnings Comparability with
Established Banks
Percent 3
Number of Banks
Percent b
Earnings Superiority of
De Novo Banks
Number of Banks
0
76
45.0
20
11.8
3
1.8
1
142
86.1
96
58.2
42
25.5
3
99
70.2
54
38.3
22
15.6
5
80
65.0
54
43.9
20
16.3
8
73
76.0
49
51.0
18
18.8
a
Percent of de novo banks at given age with ROA > 0.
b
Percent of de novo banks at given age with ROA > 80 percent of the median ROA for established
charter with up to $100 million in assets.
0
Percent of de novo banks at given age with ROA >_ 150 percent of the median ROA of established
The results of the probit model for the four
time periods studied are presented in Table 4,
along with goodness-of-fit measures. 1 1 The estimated probit model performs reasonably well
for each year. T h e e s t i m a t e d probability of
achieving the observed value (0 or 1 ) e x c e e d s 0.5
in 70 percent or more of the total c a s e s in all
years. The likelihood ratio, indicating how well
the s e l e c t e d model specification explains financial performance, is also significant in all
c a s e s at the 0.01 level. Among the individual
variables, CAPITAL and SALARIES have the expected signs with statistically significant coefficients in all four models. T h e LOANLOSS
variable is significant with the correct sign in all
years except 1988. The proportion of total loans
in consumer (CONS) and business loans (C&I) is
significant in the first year of operation, while
the share of real estate lending in total loans
(REALEST) is positive and significant in the later
years of operation. The only exogenous variable
of any significance was STATEBR (statewide
branching) in all years except the fifth.
The probit analysis results indicate that differences in operating costs, credit policy, and
leverage account for most of the performance
variations among the sample banks relative to
the established target group during the early
years of operation. Other variables—namely,
those measuring the composition of the bank's
loan portfolio (REALEST, CONS, and C&I), li20
Percent 0
banks in state of
banks.
quidity (FEDFUNDS and LOANDEP), market
structure (MSA and 3FIRMCR), and local economic conditions (CHGPI)—do not exhibit consistent, significant effects on the performance of
new banks studied during the first eight years
of operation.
T h e positive and significant coefficient on the
state branching laws variable (STATEBR) in 1981,
1983, and 1988 suggests that being chartered in
a state that allows statewide branching increases
new banks' probability of success. Statewide
branching also allows established banks to s e t
up d e novo branchés, thereby increasing the
competition i n d e p e n d e n t d e novos face. Under
these circumstances, the evidence that statewide branching enhances the financial performance of new independent banks corroborates
the arguments of Constance Dunham ( 1989) and
others that consumers prefer small independent banks over large, multioffice institutions. 12
The insignificant coefficients on the NOWACC
variable (the ratio of NOW accounts and other
savings deposits subject to interest rate ceilings
to total deposits) and LTIMEDEP (the ratios of
large time deposits to total deposits), except for
1981, are especially interesting. The Depository
Institutions Deregulation and Monetary Control
Act of 1980, which phased out ceilings on deposit rates over a six-year period, was expected
to increase competition in financial services. In
this context, the low profile of LTIMEDEP is surE C O N O M I C R E V I E W , M A R C H / A P R I L 1990
Table 4.
Results of Probit Model for Different Years of Operation
1981
(Age 1)
Variable
INTERCEPT
1983
(Age 3)
-0.09
-1.61
SALARIES
-93.70*
-58.64*
LTIMEDEP
-1.52*
NOWACC
REALEST
1985
(Age 5)
1988
(Age 8)
-5.06*
-5.79*
-55.50*
-49.65*
-1.09
1.33
-0.39
2.62
NA
NA
0.77
-0.15
4.36*
4.57*
-2.21
CONS
1.80*
0.17
3.64
3.13
C&l
2.46*
-0.80
2.08
4.30*
LOANLOSS
-39.35*
FEDFUNDS
-105.09*
-159.33*
2.97
0.16
-0.24
-2.21
LOANDEP
0.63
1.57
2.30
0.56
CAPITAL
4.29*
9.50*
34.00*
24.15*
0.07
0.61
-0.31
-0.14
-0.37
1.64
-0.17
-0.17
MSA
3FIRMCR
STATEBR
0.59*
0.66*
0.15
0.34
1.50*
LTD BR
-0.01
-0.09
-0.23
CHGPI
1.58
-4.79
1.29
2.29*
0.67
Goodness-of-Fit Measures
Number of Right Predictions
118
102
108
74
Percent of Right Predictions
72
72
88
77
Likelihood Ratio Test
36.5
55.9
94.5
34.4
Degrees of Freedom
15
15
14
14
* Statistically
significant at the 1 percent
* Statistically significant
at the 5 percent
* Statistically significant at the 10 percent
NA = Not applicable
in the indicated
level.
level.
level.
years.
prising, suggesting that d e novo banks did not
use the relaxation of interest rate ceilings to
spur growth by bidding for additional deposits.
(In fact, the ratio of large time deposits to total
deposits fell by nearly one-half at the sample
banks from 1980 to 1988). The insignificance of
NOWACC is partially attributable to the fact that,
on average, NOW accounts and other savings
deposits made up less than 10 percent of sample banks' total deposits in 1981 and 1983.
T h e coefficients on t h e liquidity variables
(FEDFUNDS and LOANDEP) were insignificant
for the most part. T h e sample banks were net
sellers of federal funds in all years, and their
FEDERAL RESERVE B A N K O F ATLANTA
loan-to-deposit ratio held constant. Contrary to
Arshadi and Lawrence's results, this study indicates that market structure variables had no
significant impact on t h e new banks' probability of success.
As noted earlier, a major advantage of using
probit analysis is that the marginal impacts of
the independent variables on a new bank's probability of s u c c e s s can b e a s s e s s e d . T a b l e 5
shows the marginal effects computed at the
means of the regressors. Operating costs and
credit policy dominate new bank performance
in the first year of operation. For example, a
ceteris paribus increase of 1 percent in the ratio
I7
Table 5.
Marginal Effects of Change in Independent Variables
On Probability of Success of De Novo Banks
1985
(Age 5)
1988
(Age 8)
Variable
1981
(Age 1 )
1983
(Age 3)
INTERCEPT
-0.03
-0.46
-0.19
-2.30
-19.75
-0.88
SALARIES
-36.50
-16.89
-2.07
LTIMEDEP
-0.59
-0.31
0.05
NOWACC
-0.15
0.75
NA
NA
REALEST
0.30
-0.04
0.16
1.82
CONS
0.70
0.05
0.14
1.25
0.96
-0.23
0.08
1.71
-15.33
-30.26
-5.93
1.18
FEDFUNDS
0.06
-0.07
-0.08
0.13
LOANDEP
0.25
0.45
0.09
0.22
C&l
LOANLOSS
CAPITAL
1.67
2.73
1.27
9.61
MSA
0.03
0.18
-0.01
-0.06
-0.14
0.47
-0.01
-0.07
0.23
0.19
0.01
0.59
3FIRMCR
STATEBR
LTDBR
-0.00
0.03
-0.01
0.27
CHGPI
0.61
-1.38
0.05
0.91
NA = Not applicable
in the indicated
years.
of wages and salaries to total assets (SALARIES)
reduces the probability of financial success of
new banks by 36.5 percent. An increase of similar magnitude in the ratio of loan losses net of
charge-offs to total loans (LOANLOSS) lowers
the probability of success by 15 percent. Although t h e relative importance of operating
costs and credit policy (as measured by their
marginal impacts) declines in the four years
examined, t h e s e two factors clearly dominate in
explaining overall d e novo bank success. The
marginal impact of CAPITAL is strongest in the
eighth year of operation. The remaining statistically significant i n d e p e n d e n t variables
showed small marginal effects.
significant in most years examined. T h e s e findings are consistent with those of s o m e earlier
studies and emphasize the appropriateness of
the OCC's stress on managerial c o m p e t e n c e in
evaluating charter proposals. T h e results do not
imply that factors exogenous to managerial decision making are unimportant. Nonetheless,
the findings clearly show that b a n k survival
d e p e n d s largely on factors directly under the
bank management's control.
This study points to the importance of factors
endogenous to the decision-making process at
i n d e p e n d e n t d e novo banks in determining
their financial performance. Controlling operating costs and loan portfolio quality clearly are
critical in the early stages. Two other factors—a
bank's equity capitalization and its location in a
state that allows statewide branching—are also
This article has identified the factors, both
bank-specific and exogenous, most critical in
determining the probability of financial success
in independent d e novo banks. Three bankspecific (internal) characteristics appear to b e
the primary determinants of newly chartered
banks' likelihood of achieving financial success:
credit policy, measured by the bank's ratio of
22
Conclusions
E C O N O M I C R E V I E W , M A R C H / A P R I L 1990
net loan l o s s e s to total a s s e t s ; operating costs,
indicated by t h e ratio of wages and salaries to
total a s s e t s ; and t h e level of equity capitalization. Other factors, such a s loan portfolio c o m position and s t a t e branching laws, were found
to b e l e s s significant. Variables often c o n s i d e r e d i m p o r t a n t d e t e r m i n a n t s of d e novo
banks' success—such a s market concentration
and local e c o n o m i c conditions—evidence no
consistent, significant effect in this analysis.
While t h e s e findings are generally c o n s i s t e n t
with previous research, two characteristics distinguish t h e s e conclusions. First, t h e u s e of t h e
probit analysis t e c h n i q u e allowed various b a n k
and market factors to b e ranked according to
their relative importance in predicting financial
s u c c e s s . S e c o n d , by c o m p a r i n g t h e financial
performance of s a m p l e banks with similar, es-
t a b l i s h e d banks in t h e s a m p l e banks s t a t e s ' of
charter, p o s s i b l e b i a s e s d u e to regional e c o nomic differences were avoided.
B e c a u s e this research included only s a m p l e
banks surviving for t h e entire eight-year period,
attributing its results to all d e novo b a n k s would
b e i n a p p r o p r i a t e . Clearly, an a r e a worthy of
further study is t h e financial performance of d e
novo b a n k s that failed, that were merged with or
acquired by other banks, or that m a d e acquisitions t h e m s e l v e s . With t h e proper c h o i c e of
methodology, such research can provide e m pirical e v i d e n c e on t h e attributes important in
determining t h e duration of newly c h a r t e r e d
banks a s i n d e p e n d e n t entities a s well as t h e diff e r e n c e s b e t w e e n banks that fail during t h e
start-up p h a s e and t h o s e that fail after b e c o m ing e s t a b l i s h e d .
A Description of the Probit Technique
To understand how the probit model works in
this study, assume that there exists an index S(that measures de novo bank performance relative
to established banks of similar size in the state of
charter. S ( is chosen so that the higher its value is,
the greater the likelihood that the bank will be
financially successful. S,- is hypothesized to b e a
linear function of bank-specific attributes and
market and regulatory factors:
Sj = a + pXj.
(1)
In addition, it is assumed that associated with
each bank is a critical value S* of the index S(.
such that:
if Sj > S*, the bank is financially successful;
if Sj < SJ, the bank is financially unsuccessful.
(2)
The probit model assumes that S* is a normally
distributed random variable so that the probability that SJ is less than or equal to Sf- can b e
computed from the cumulative normal probability
function. The cumulative normal probability function is written as follows:
By construction, the variable Pf. will lie in the
(0,1) interval.
To obtain the variable S(-, which is assumed to
be linear in the unknown parameters, ¡3, the inverse of the cumulative normal function is appl ied
to equation (3):
Sj = F~]
(Pj) = a + (iXj.
(4)
The probability P(- resulting from the probit model may b e interpreted as an estimate of the conditional probability that a bank will be financially
successful.
It is important to note that the parameters of the
model are not necessarily the marginal effects
analyzed in the general linear model. In general,
- ^
= f { a + pXj)p,
(5)
where f (•) is the density function corresponding
to the cumulative distribution F (•). These derivatives predict the effect of changes in one of the
independent variables on the probability of being
successful. For the probit model, f (•) is <}>(t), the
standard normal density function.
I7
FEDERAL RESERVE BANK O F ATLANTA
Notes
1
2
Most previous studies of bank profitability determinants
have examined one or more of the following issues:
economies of scale, market concentration, and financial
ratios associated with bank profitability. This study most
closely approximates the third line of research as exemplified in studies conducted by Fraser and Rose (1972),
Fraser, Phillips, and Rose (1974), Kwast and Rose (1982),
Wall (1983), and Nejezchleb (1988).
Studies by Alhadeff and Alhadeff (1976), Arshadi and Lawrence (1987), Austin and Binkert (1975), Huyser (1986), Martin and Sauter (1986), Tufts and Struck (1984), and Yeats,
Irons, and Rhoades (1975) look at various aspects of new
bank financial performance. More recent studies by Dunham (1989) and Rose and Savage (1989) examine new bank
formation rates and market share accumulation, respectively.
% e e Maddala (1986) and Pindyckand Rubinfeld (1976) for
an in-depth look at the probit technique.
4
Note that the probit model is used in this article to classify
the sample banks as successful based on observable
characteristics. The statistical tests are descriptive and
are not derived from a formal model of financial success.
5
Bank asset size is not included as a separate variable
since the performance measure, ROA, involves the normalization of net income by asset size, thereby enabling
the researchers to control for differences in bank size and
the possible effects of economies of scale. The average
asset size of the sample banks was $14.8 million in 1981
and $49 million in 1988.
6
Many of these variables have been used as determinants
of financial success in previous studies of de novo bank
performance. See, for example, Arshadi and Lawrence
(1987), Fraser, Phillips, and Rose (1974), Gilbert and Peterson (1975), Gilbert (1984), Kwast and Rose (1982), Rhoades
and Savage (1985), Rose and Savage (1984), and Rose
(1977, 1988).
7
lt could b e argued that better-capitalized de novo banks
are more likely to survive simply because they can finance
their assets less expensively than can weakly capitalized
de novo banks. While this argument certainly applies to
larger banks that rely on purchased funds for asset growth,
it does not typically apply to d e novo banks that rarely
engage in the practice of liability management.
h h e local market or primary trade area is defined as either
the MSA or the non-MSA county where the sample bank
is located.
\ h e poorer the economic conditions in a given area, the
fewer should be the number of new bank charter applications in that area. However, one would still expect a positive relationship at the margin between local economic
conditions and financial success.
l0
In 1981, 69 sample banks were classified as unsuccessful
(ROA less than 80 percent of the median benchmark). In
1983, 1985, and 1988 the number of banks classified as
unsuccessful was 89, 69, and 47, respectively.
" T h e goodness-of-fit measures indicate the accuracy with
which a model approximates the observed data (like the
R2 in linear regression models). In the case of qualitative
dependent variables, accuracy can be judged either in
terms of the fit between the calculated probabilities and
observed frequencies (percent of right predictions) or the
maximum of the likelihood function.
12
Rose and Savage (1989) also conclude that liberal branching privileges for existing banks do not adversely affect
market share accumulation by new banks.
References
Alhadeff, David A., and Charlotte P. Alhadeff. "Growth and
Survival Patterns of New Banks, 1948-1970." Journal of
Money, Credit, and Banking 8 (May 1976): 199-208.
Arshadi, Nasser, and Edward C. Lawrence. "An Empirical
Investigation of New Bank Performance." Journal of Banking and Finance 11 (March 1987): 33-48.
Austin, Douglas V., and Christopher C. Binkert. "A Performance Analysis of Newly Chartered Banks." Magazine of
Bank Administration
51 (January 1975): 34-35.
Dunham, Constance R. " N e w Banks in New England."
Federal Reserve Bank of Boston New England Economic
Review (January/February 1989): 30-41.
Fraser, Donald R., R. Wallace Phillips, and PeterS. Rose. "A
Canonical Analysis of Bank Performance." Journal of
Financial and Quantitative
Analysis 9 (March 1974):
287-95.
Fraser, Donald R„ and PeterS. Rose. "Bank Entry and Bank
Performance." Journal of Finance 27 (March 1972): 65-78.
Gilbert, Gary G., and Manferd O. Peterson. "The Impact of
Changes in Federal Reserve Membership on Commercial
Bank Performance." Journal of Finance 30 ()une 1975):
713-19.
24
Gilbert, R. Alton. "Bank Market Structure and Competition."
Journal of Money, Credit, and Banking 16 (November
1984): 617-45.
Huyser, Daniel. "De Novo Bank Performance in the Seven
Tenth District States." Federal Reserve Bank of Kansas
City Banking Studies ( 1986) : 13-22.
Kwast, Myron, and lohn T. Rose. "Pricing, Operating Efficiency, and Profitability Among Large Commercial Banks."
Journal of Banking and Finance 6 (March 1982): 233-54.
Maddala, G.S. Limited-Dependent
and Qualitative Variables in Econometrics. New York: Cambridge University
Press, 1986.
Martin, Larry W„ and Diane R. Sauter. "Analysis of High and
Low Performance De Novo Banks." Bank
Administration
62 (April 1986): 34, 36, 40.
Nejezchleb, Lynn A. "Some Evidence on the Nature of Bank
Profitability Problems." Paper presented at the Eastern
Economic Association Meetings, Boston, Massachusetts,
March 10-12, 1988.
Office of the Comptroller of the Currency. News Release.
October 2, 1980.
E C O N O M I C R E V I E W , M A R C H / A P R I L 1990
Pindyck, Robert S., and Daniel L. Rubinfeld. Econometric
Models and Economic Forecasts. New York: McGrawHill, 1976.
Rhoades, Stephen A , and Donald T. Savage. "The Viability
of the Small Bank." The Bankers Magazine 168 d u l y /
August 1985): 66-72.
Rose, John T. "The Attractiveness of Banking Markets for De
Novo Entry: The Evidence for Texas." Journal of Bank
Research 7 (Winter 1977): 285-93.
"New Independent Bank Entry in an Era of
Financial Deregulation." Review of Research in Banking
and Finance 4 (Fall 1988): 45-59.
Rose, JohnT„ and Donald T. Savage. " D e Novo Entryand Performance: Bank Holding Companies versus Independent
Banks." Journal of Bank Research 15 (Summer 1984):
95-107.
FEDERAL RESERVE B A N K O F ATLANTA
Rose, lohn T„ and Donald T. Savage. "New Independent
Banks and Market Share Accumulation in a Deregulated
Environment." Unpublished paper, 1989.
Tufts, Roger W., and Peter L. Struck. "The Performance of
New Banks Under the Revised OCC Chartering Policy."
Office of the Comptroller of the Currency Doc. #0125B,
September 17, 1984.
Wall, Larry D. "Why Are Some Banks More Profitable? A
Statistical Cost Analysis." Federal Reserve Bank of Atlanta Economic Review 68 (October 1983): 44-51.
Yeats, Alexander J., Edward D. Irons, and Stephen A.
Rhoades. "An Analysis of New Bank Growth." Journal of
Business 48 (April 1975): 199-208.
I7
Measuring Interstate Migration
William ). Kahley
t's hard to b e a t warm weather and jobs. An
attractive climate and rapid employment
growth help explain why states like Florida and Georgia attracted so many new residents
in the 1980s that their population grew by about
30 percent and 18 percent, respectively, while
the nation's grew only by 11 percent. Measuring
state-to-state migration and understanding its
causes are important b e c a u s e the effects of
t h e s e population flows are significant for both
the receiving and sending areas.
I
mists but also developers, bankers, utility companies, and, perhaps most of all, state and local
planners and policymakers—can tap a variety of
information sources to monitor and understand
the size, direction, and composition of migration. For policymakers, this information is essential to weighing inmigration's c o s t s and
b e n e f i t s and formulating appropriate policy
responses.
Unfortunately, data on migration from state to
state are often not available on a timely basis.
The Census of Population is the b e s t source of
information, but it is available only once every
10 years. T h e 1990 census, now being compiled,
will not b e available until 1991 on computer
tapes and 1992 or 1993 in print. In addition, the
statistical s e r i e s on migration entail various
m e a s u r e m e n t p r o b l e m s that users must b e
aware of before drawing conclusions and inferences. 1 With proper caution, however, those
interested in population movements from state
to state—not only demographers and econo-
Inmigration can raise incomes, fuel job growth,
stimulate demand for housing and other types
of construction, and generally promote economic development. 2 A rapid population influx
can also result in congestion, pollution, and
increased need for public transportation, schools,
and other infrastructure investment that creates
added burdens for state and local governments.
Thus, knowing the age profile of migrants, for
example, is useful in determining future capacity n e e d s for schools, hospitals, and retirement
homes. Details regarding migrants' assets or
income sources, skills, and education are likewise helpful in planning for community support systems.
The author is an economist in the regional section of the
Atlanta Fed's research department. He thanks Amy Bailey
for research assistance.
This article reviews and evaluates the strengths
and weaknesses of the various interstate migration information sources. It also applies this
analysis to southeastern data to demonstrate
what available figures reveal about migration in
26
E C O N O M I C R E V I E W , M A R C H / A P R I L 1990
and out of t h e s e six states—Alabama, Florida,
Georgia, Louisiana, Mississippi, and Tennessee—
during the 1980s. 3 In pointing out the lags, weaknesses, and shortcomings of certain data series,
no criticism or j u d g m e n t of t h e r e s p o n s i b l e
organization is intended. Availability problems,
for e x a m p l e , are virtually unavoidable. T h e
United States is a nation of great geographic
expanse with no state border controls or national register for citizens. Hence, collecting
migration information is expensive. Gathering
detailed data at the national level raises costs
further, as d o e s compiling figures about migration patterns in particular regions, states, or
localities. For these reasons the U.S. government obtains migration data on an infrequent
basis and from samples rather than the population as a whole. Federal agencies also collect
more detailed information for the nation than
for individual states or metropolitan areas.
The n e e d to rely on samples introduces certain statistical problems. The magnitudes of
sampling and nonsampling errors affect the
accuracy of migration estimates. Chance variability in estimating occurs when surveying only
a portion of the population; in other words, the
estimated number will differ depending on the
sample drawn from the surveyed population.
Nonsampling errors occur for numerous reasons: r e s p o n s e s may b e incomplete, leaving
gaps in information; categories might b e imprecise; p e o p l e may interpret questions in different ways; and s o m e of those surveyed are
likely to b e unable or unwilling to respond correctly or to recall all the information sought.
Recording and coding the data collected also
introduce potential errors, and mistakes can b e
made while processing data.
Despite t h e s e problems, existing data measurement sources can yield careful users a surprising amount of information about migration
at the state level. Researchers can u s e certain
statistical methods to adjust migration data for
s o m e measurement problems and to understand better what the data indicate. While timeliness and level of detail remain difficult issues,
one can trace noteworthy patterns and shifts in
migration by examining not only the decennial
Census of Population but also the U.S. Census
Bureau's Current Population Survey and its
yearly s t a t e population e s t i m a t e s from t h e
Components of Population Change. Internal
Revenue Service data also can b e used to produce migration estimates, as can information
from the private sector, such as moving company shipments.
Before reviewing t h e s o u r c e s of migration
information released between the population
c e n s u s e s conducted in 1980 and 1990, as a backdrop to t h e s e series this article briefly discusses
the migration information that can b e obtained
from the 1980 census. Table 1 summarizes key
attributes of the data sources, including their
frequency, sample size or migration universe,
and level of geographic and demographic detail.
Migration Data Sources
1 9 8 0 Census of Population. The U.S. government, by constitutional mandate, has undertaken a census of population every 10 years
since 1790. Since the early 1900s the U.S. Commerce Department's Bureau of the Census has
produced the census. In the 1980 census (and in
the one just conducted) the source of migration
information is a question regarding tenure of
r e s i d e n t s : r e s p o n d e n t s were a s k e d whether
they were living in the s a m e house five years
earl ier, and, if not, in what U.S. state, county, city
or town, or foreign country they 1 ived earl ier. T h e
survey also asked whether their residence was
within or outside the city/town limits. Census
takers use the answers to t h e s e questions about
residence in 1975 and 1980 to determine the
U.S. population's geographic mobility. For example, a 1980 resident of Atlanta, Georgia, who
responded that she lived in York, Pennsylvania,
five years earl ier would have b e e n counted as an
outmigrant from Pennsylvania and an inmigrant
to Georgia. Three of the "supplementary reports" series publish migration data from the
1980 census. Statistics are also available from
computer t a p e files.
From several perspectives the Census of Population is the b e s t single information source on
population mobility although even it has certain
shortcomings. Census migration data generally
are more comprehensive, give greater information a b o u t migrant characteristics, and offer
more geographic detail. The decennial census
counts the overall number of migrants during a
I7
F E D E R A L RESERVE B A N K O F ATLANTA
fixed t i m e period and provides gross a s well a s
net migration streams among states. However,
t h e s e data are b a s e d on a sample, a l b e i t a very
large one, and thus are s u b j e c t to t h e kind of
sampling error discussed above. In addition,
s o m e inaccuracy arises from t h e five-year period
covered by t h e mobility question. P e o p l e who
moved away from and t h e n returned to t h e s a m e
s t a t e within t h e 1975-80 period would not appear in t h e tally of interstate migrants, nor would
t h o s e who m o v e d after 1975 b u t t h e n d i e d
b e f o r e April 1, 1980. Meanwhile, o t h e r s who
moved two or m o r e t i m e s during t h e period
would b e c o u n t e d only once.
Aside from t h e s e p r o b l e m s with t h e 1980 census, a major historical g a p in migration data
exists b e c a u s e t h e r e is no standard r e f e r e n c e or
reliable s o u r c e of p r e c i s e net migration estim a t e s by age, sex, and race at t h e s t a t e and
county level during t h e 1970s, nor will t h e r e b e
such a b e n c h m a r k s e r i e s for t h e 1980s. T h e
decennial c e n s u s d o e s not ask a b o u t all migration s i n c e t h e previous census, and t h e amount
of migration c a n n o t b e d e d u c e d from c e n s u s
data for, say, 1970 and 1980. As o n e prominent
r e s e a r c h e r s t a t e s t h e p r o b l e m , " T h e higher
level of coverage in t h e 1980 c e n s u s c o m p a r e d
with t h e 1970 c e n s u s prohibits strict application
of previous (estimating) methods, and t h e r e is
now no satisfactory m e t h o d for adjusting subnational areas for differential undercount in t h e
two c e n s u s e s . " 4 In other words, b e c a u s e t h e
n u m b e r s for population stocks are not strictly
c o m p a r a b l e , t h e p r e c i s e amount of migration
flow s u g g e s t e d by c o m p a r i n g t h e s t o c k s is
wrong. Counting black men has proven particularly difficult. Census takers also find it hard
to e n u m e r a t e illegal residents, t h e h o m e l e s s ,
and t h o s e who distrust government. Population
e s t i m a t e s for geographic areas containing high
concentrations of t h e s e groups may b e s u b j e c t
to substantial error.
A final shortcoming of c e n s u s migration data
results from its relative infrequency. S i n c e c e n sus taking is a decennial event, significant shifts
in migration s t r e a m s b e t w e e n c e n s u s e s can g o
unnoticed or, m o r e likely, b e very much underor overestimated.
Current Population Survey. A ready source of
i n t e r c e n s a l information on migration is t h e
Current Population Survey. Each m o n t h t h e
Current Population Survey, a division of t h e U.S.
28
Census Bureau, c o l l e c t s labor force data for t h e
noninstitutional civilian population from a sample of 57,000 households. Every March interviewers ask supplementary migration questions.
As in t h e Census of Population, information on
mobility is derived from answers to q u e s t i o n s
on r e s i d e n c e o n e year b e f o r e t h e survey d a t e
and t h e geographical location of t h e respond e n t ' s current r e s i d e n c e . T h e survey's estimation p r o c e d u r e extrapolates weighted s a m p l e
results to various age, sex, and race categories.
Data from t h e annual surveys are p u b l i s h e d in
s e r i e s P-20 of t h e Current Population
Reports;
microdata c o m p u t e r files are also available for
each survey beginning with 1968.
In s o m e ways Current Population Survey data
may b e superior to t h o s e from t h e Census. T h e
Current Population Survey staff is permanent,
whereas this year t h e Census Bureau e m p l o y e d
temporary workers—more than 450,000 in 1990—
to h e l p t a k e t h e c e n s u s . Among t h e s e , 200,000
enumerators visited t h e h o m e s of p e r s o n s who
did not return their questionnaires. T h e smaller
size of t h e t h e Current Population Survey operation also facilitates closer surveillance and control. Moreover, t h e yearly frequency of t h e Current Population Survey m a k e s t h e s e data m o r e
s u i t a b l e for studying and analyzing t i m e trends
and cyclical m o v e m e n t s in t h e statistics.
Perhaps t h e major drawback of t h e Current
Population Survey data inheres in t h e s a m p l e
size: b e c a u s e only 57,000 h o u s e h o l d s are surveyed, details on geographic mobility are statistically val id only for t h e nation as a whole and its
four major c e n s u s regions—the Northeast, Midwest, South, and West. Moreover, t h e range of
migration e s t i m a t e s , within which 95 out of 100
survey s a m p l e s , say, would fall, is quite large.
For example, t h e Census South's n e t gain from
migration in 1986-87 is e s t i m a t e d at 279,000 plus
or minus 193,000, and t h e Midwest's 111,000
e s t i m a t e d n e t outmigration is not statistically
significant. Another s h o r t c o m i n g is that t h e
data, while available yearly, are p u b l i s h e d with
a c o n s i d e r a b l e lag—usually a b o u t two years and
s o m e t i m e s longer. T h e March 1988 survey results will not b e p u b l i s h e d until late this year
b e c a u s e t h e C e n s u s Bureau staff has b e e n working on t h e 1990 Census. Data on c o m p u t e r t a p e
are available with a lag of a b o u t o n e year. 5
Components of Population Change. A s o u r c e
of m o r e geographically d e t a i l e d yet still freE C O N O M I C R E V I E W , M A R C H / A P R I L 1990
Table 1.
Sources of Migration Data
Source
Geographical
Detail
Flows
Personal
Characteristics
Migration
Universe/Sample
Frequency
Census migration data are reported in: State of
Residence in 1975 by State of Residence in
1980 (PC80-S1 -9); Residence in 1975 for
States, by Age, Sex, Race, and Spanish Origin
(PC80-S1-16); Gross Migration for Counties:
1975 to 1980 (PC80-S1-17); and Vol. 2, Subject Reports: Geographical Mobility for States
and the Nation and Mobility for States and the
Nation and Mobility for Metropolitan Areas
(PC80-2-2C). All from the Bureau of the Census.
United States,
region, division,
state, and
county
In-Out-Net
Depends on report;
may include age, sex,
race, Hispanic origin,
marital status, education, labor force
status, occupation,
and income.
Sample is 10 percent
of census responses.
Decennial starting in
1940. Most recent is
1980.
Migration data from March Current Population
Surveys are from micro-data files or from the
published reports in the Current Population
Reports series: Mobility of the Population of the
United States: March 1986 to March 1987 (P20, no. 430) from the Bureau of the Census.
United States,
region
In-Out-Net
Age, sex, race, Hispanic origin, education, labor force
status, income,
occupation.
Sample is 57,000
households from
civilian noninstitutional households and
members of the
Armed Forces.
Annual since 1948,
but data are not available for 1972-75 or
1977-80. Most recent
is 1986-1987.
Estimates of net migration for states and counties are prepared annually by the Bureau of the
Census and published in the P-25 and P-26
series of Current Population Reports. See, for
example, State Population Estimates by Age
and Components of Change: 1980 to 1989,
Current Population Reports, series P-25, no.
1058 (Washington, D.C.: U.S. Government
Printing Office, 1990).
United States,
region, division,
state, and
county
Net
None
Estimate for resident
U.S. population
derived from administrative records and
statistical techniques.
Annual since 198081. Most recent is
1988-89.
Individual Master File, Internal Revenue Service, U.S. Department of Treasury.
State and county
In-Out-Net
None
U.S. income tax filers
Annual since 1980;
also 1970-73; 197576; 1976-77; 197879. Most recent is
1986-87.
Allied Van Lines and United Van Lines.
State
In-Out-Net
None
Company customers
Annual since 1983 for
Allied and since 1979
for United.
q u e n t data on migration is t h e Census Bureau's
annual e s t i m a t e of t h e c o m p o n e n t s of population change—births, deaths, and net migration—
for states, metropolitan areas, a n d c o u n t i e s as
of July 1. Net migration, along with total population e s t i m a t e s , is derived via t h e averaging of
e s t i m a t e s from two m e t h o d s . O n e is t h e "comp o s i t e " procedure, which u s e s vital statistics
(information on births and deaths), school enr o l l m e n t figures, a n d ratio-correlation t e c h niques in making t h e e s t i m a t e s . T h e s e c o n d
m e t h o d is a " c o m p o n e n t " p r o c e d u r e that relies
on administrative records such a s individual
i n c o m e tax returns t o e s t i m a t e internal migration and immigration reports to calculate n e t
immigration from a b r o a d . 6
Even though t h e C o m p o n e n t s of Population
Change d o e s not m e a s u r e net migration at t h e
s t a t e and local level directly, this s e r i e s is useful
for estimating migration flows among states,
large cities, and counties—areas for which t h e
Current Population Survey d o e s not provide
yearly e s t i m a t e s . For example, o n e can u s e t h e
C o m p o n e n t s of Population Change to c o m p a r e
metropolitan area growth rates and t h e c o n tribution of migration (internal and international) to an area's population growth. Also, t h e
c o m p o n e n t s data for s t a t e s are available on a
m o r e timely b a s i s than are t h e Current Population Survey data: e s t i m a t e s for t h e year ending
July I, 1989, were available on D e c e m b e r 31,
1989, six m o n t h s after t h e r e f e r e n c e date.
A major drawback of C o m p o n e n t s of Population Change data is their q u e s t i o n a b l e accuracy.
Annually t h e Census Bureau p u b l i s h e s a revised
e s t i m a t e for t h e cumulative net migration figure
since 1980. T h e C e n s u s Bureau d o e s not publish
data that give t h e yearly residual net migration
e s t i m a t e s c o n s i s t e n t with t h e cumulative numb e r that is p u b l i s h e d in t h e Current
Population
Reports series, although t h e s e are provided
upon r e q u e s t . While t h e agency considers t h e
yearly data u n a c c e p t a b l e for publication, noting
that it " c a n n o t d e f e n d t h e u s e of any individual n u m b e r s , " it d o e s say that " t h e annual figu r e s may b e indicative of g e n e r a l migration
trends."7
Still, t h e C o m p o n e n t s of Population Change
data have other major failings. They d o not provide information on gross inmigration and outmigration flows, nor d o they give any information on migrant characteristics. Also, t h e 1989
30
e s t i m a t e s are t h e most q u e s t i o n a b l e in t e r m s of
accuracy s i n c e t h e population b a s e , or " h e a d
count," to which estimating t e c h n i q u e s were
a p p l i e d was nine years old. B e c a u s e of error
accumulation, t h e further t h e annual derived
e s t i m a t e s are from t h e b a s e year, t h e worse they
become.
Internal Revenue Service Data. While t h e
C e n s u s Bureau is t h e main government s o u r c e
of migration statistics, t h e Internal R e v e n u e Service (IRS) has s t a t e - t o - s t a t e migration flow data
for m o s t years since 1970 and county-to-county
data for s e l e c t e d t i m e p e r i o d s b e t w e e n 1978
and 1986. T h e s e statistics, g e n e r a t e d from t h e
IRS data by t h e Census Bureau, are not as current as t h e C o m p o n e n t s of Population Change
series, but they give m o r e detail. Information
c o l l e c t e d c o m e s from administrative records of
"One can use the Components of Population Change to compare metropolitan area growth rates and the
contribution of migration (internal
and international) to an area's population growth."
income tax returns filed with t h e IRS. T h e migration e s t i m a t e s were d e v e l o p e d by matching t h e
Social Security n u m b e r of primary taxpayers and
comparing a d d r e s s e s on returns in c o n s e c u t i v e
years. T h e total e x e m p t i o n s claimed by taxpayers with t h e s a m e Social Security n u m b e r
b u t different a d d r e s s e s indicates t h e n u m b e r of
p e r s o n s moving.
An advantage of this s e r i e s c o m p a r e d with
t h e other intercensal migration data s o u r c e s is
that it provides p l a c e - t o - p l a c e migration flows
b a s e d on t h e a d d r e s s e s supplied on individual
income tax returns. Thus, it is p o s s i b l e t o identify which a r e a s are sending many or few p e o p l e
to a given p l a c e and which are receiving many or
few p e o p l e from another place. Information also
is available at t h e county level.
However, certain limitations of t h e s e data
c a u s e IRS e s t i m a t e s to differ from actual migration flows. First, p e o p l e a r e e x c l u d e d if their
E C O N O M I C R E V I E W , M A R C H / A P R I L 1990
income is below the required minimum for filing. Second, the methodology assumes that all
the p e o p l e listed as exemptions on tax returns
move with the tax filer. Finally, the residences of
taxpayers who file through the office addresses
of their bankers, lawyers, or accountants will not
b e accurately reflected in the data. Overall, IRS
data underestimate the actual total migration
flow.
Another major shortcoming of IRS data is that
information for 1985-86 and 1986-87 was determined to b e inaccurate for s e l e c t e d states, including Florida and Georgia. In response, migration flows b a s e d on the IRS data have b e e n
reestimated by the Census Bureau for t h e s e
years using a revised estimation methodology. 8
The new methodology also is being used to
estimate migration flows for 1987-88. Unfortu-
"[Moving company shipmentsl data
do not accurately indicate the actual
magnitudes of migration streams but
are still valuable because they can
point to changes in the size or direction of state migration."
nately, the revised data were not available as of
March 1990, further reducing the timeliness of
the estimates.
Moving Company Shipments. Two o t h e r
sources of migration data c o m e from the private
sector. Moving companies such as Allied Van
Lines and United Van Lines r e l e a s e information
on the number of state inbound and outbound
shipments to each state handled by their companies each year. Both Allied and United claim
in news releases that their company data on
interstate household goods shipments are representative of the nation's mobility patterns. In
1989 the number of such shipments was 165,000
for Allied and more than 172,000 for United.
Because of their timeliness moving company
shipments data can offer valuable information
insofar as they accurately reflect U.S. migration
patterns at the state level. T h e s e data provide
the most current information generally avail-
a b l e that deals with interstate migration; data
on shipments for all of 1989 b e c a m e available
just one month into 1990.
However, moving company data have certain
drawbacks. First, it is not possible to determine
the accuracy of the data as a measure of migration. To a degree, the flows reflect particular
movers' market shares in different states. It is
encouraging, though, that the series are highly
correlated with each other and with the Current
Population Survey data when aggregated to the
census region level. In general, correlations of
t h e s e data with the other available information
series on migration tend to show higher associations for the inmigration and outmigration
series than for the net migration series (see the
box on page 32).
Another shortcoming is that moving company
shipments data reflect only a portion of total
interstate migration b e c a u s e many migrants
move t h e m s e l v e s . In particular, p e o p l e with
lower incomes or seeking employment are more
likely to undertake their own move, whereas
those with higher income jobs (or their employers) hire moving companies. Movers' data
also may b e procyclical. If jobs are plentiful,
more households and companies are likely to
hire movers. When j o b s a r e scarce, families
forgo this e x p e n s e and move themselves.
Given the limitations noted, t h e s e data do
not accurately indicate the actual magnitudes of
migration streams but are still valuable b e c a u s e
they can point to changes in the size or direction
of state migration. Although moving company
s h i p m e n t s data do not provide information
about place-to-place migration or the characteristics of those moving, several other data
sources have the s a m e gap.
Moving company shipments statistics are not
the only source of migration data in the corporate sector. Records regarding customers or
clients of utility companies, such as new hookups by electric power companies and billing
address changes, can provide valuable insights
into shifts and migration gains at the local level.
Similarly, changes of addresses among credit
card or banking account holders could yield
additional information concerning migration.
Data like t h e s e may b e especially helpful at
the metro or county level in making migration
estimates on a timely basis. For example, new
hookups figures might b e used to estimate POPI7
FEDERAL
RESERVE B A N K O F ATLANTA
Associations a m o n g t h e Data S e r i e s
How closely do the different migration estimates discussed in the text conform to each
other? Except for moving company data, it is not
possible to compare migration estimates directly
because the measures differ in their timing and
coverage of interstate migration. Nevertheless, as
measured by the Pearson correlation coefficient,
the different sources of migration tend to move
in tandem.
The correlation coefficient, denoted by r, is a
summary number that quantifies the strength of
the association between two variables. It is defined as
n
r =
E (x,. - X) (y f i ^ j
y)
(N — l ) S x S y
where N is the number of cases; Sx S y are standard
deviations of the two variables; X, V are sample
means; and X/( Vf are sample observations. The
absolute value of r indicates the strength of the
linear relationship. The largest possible absolute
value is one, which means that a change in X determines exactly an increase in Y (and vice versa); a
value of zero indicates no linear association.
Calculation of correlation coefficients for the
Allied Van Lines and United Van Lines interstate
household shipments data for each of the seven
years from 1983 through 1989 yielded the following coefficients: for inbound shipments the value
was .98 for each year except 1983's value of .97;
values ranged from .93 to .96 for outbound shipments and from .67 to .91 for net shipments. Statistically, these associations are very strong, suggesting that the two data series tell much the same
story.
Calculation of correlation coefficients for other
pairwise comparisons are shown in the accompanying table. Overall, these association patterns
suggest that the different data series, though not
perfectly aligned, tend to be strongly associated.
The weakest associations are between the moving
company data and the Components of Population
Change data in 1988 and 1989. The Components of
Population Change data show outmigration for
Alabama in the 1987-88 and 1988-89 period,
whereas moving company data show net inmigration for 1987, 1988, and 1989. The results of the
1990 Census may eventually determine which estimate was correct. (Note, too, that the Components
of Population Change data include immigrants.)
Pearson Correlation Coefficients for Migration Data
CPS
Current
Population Survey
(CPS)
IRS
MCS.
MCS,
net = .77
in = .94
out = .75
net = .89
in = .92
out = .89
net = .79
in = .92
out = .87
net = .77
1983-89
.12-.91
1983-89
.41-.87
.92-,98
.92-.98
Components of
Population Change
(COP)
net = .77
Internal
Revenue Service
(IRS)
in = .94
out = .75
net = .89
1980-81-1985-86
.81-.92
Moving Company
Shipments (Allied Van
Lines) (MCS A )
in = .92
out = .89
net = .79
1983-89
.12-.91
,92-.98
Moving Company
Shipments (Allied Van
Lines and United
Van Lines)
(MCSA+U)
in = .92
out = .87
net = .77
1983-89
.41-.87
.92-.98
* Net comparisons
32
COP*
1980-81-1985-86
.81-.92
only.
E C O N O M I C R E V I E W , M A R C H / A P R I L 1990
ulation growth, using historical ratios for average
household size and households per hookup.
O n e could then calculate residual migration
using vital statistics data on births and deaths
by applying the "demographic equation":
M = (p, - p 0 ) - (6 - D),
where M represents net migration, p ( and p 0
stand for population in the current (P|) and b a s e
(p0) period, B equals births, and D, deaths during the period. In other words, net migration
equals total population change less the natural
increase over the time interval.
This methodology, as might b e e x p e c t e d ,
entails s o m e difficulties. For example, average
household size has b e e n declining, and this
decline would need to b e reflected in the ratio
analysis. Aside from this technical issue and certain others, hookups data are proprietary and
thus analysts and r e s e a r c h e r s may not have
access to them, particularly if the electric utility
company d o e s not regularly process and summarize them. Even if available, such data could
b e c u m b e r s o m e or expensive to prepare for
detailed analysis. Nonetheless, even raw data
on hookups or building contractor advance
orders for hookups could h e l p to i n d i c a t e
whether migration is augmenting or draining an
area's population growth.
Case Study: Shifting Migration
Patterns in the Southeast
Information from the migration sources reviewed above can help construct the likely patterns of southern migration in t h e 1980s. In
doing so, it is tempting to use the numbers to
support various hypotheses that claim to explain why particular patterns appear. However,
using these statistics in this way is risky. Whether
migrants follow jobs or vice versa, for instance, is
an unresolved issue among researchers d e s p i t e
their u s e of s o p h i s t i c a t e d statistical techniques.
What r e c e n t Census of Population d a t a
show. The Census of Population provides the
most accurate measures of mobility and Change
in mobility over time, notwithstanding its shortcomings, which are probably inherent or very
costly to remedy. When new census mobility
data b e c o m e available, researchers in s o m e
instances are surprised, but more often t h e s e
statistics simply confirm trends and patterns
already suggested by observation or other data.
For example, comparison of interregional migration patterns using 1970 and 1980 census
data revealed several significant but e x p e c t e d
changes in southern migration patterns: 9
• net migration losses, which had b e e n typical
throughout the twentieth century for most
southern states, were reversed in the 1970s,
and for the first time interregional migration
added to the S o u t h s population;
• experienced workers were becoming a more
d o m i n a n t force in t h e S o u t h s migration
gains;
• the South gained workers in all the broad
o c c u p a t i o n a l c a t e g o r i e s in t h e l a t e 1970s,
whereas mostly white collar workers and
skilled craftsmen flowed to the South during
the late 1960s;
• the South benefited from a North-to-South
"brain drain" as a result of migration;
• migration to t h e South h e l p e d lower t h e
incidence of southern poverty; and
• migration started adding more women than
men to the South's population.
Eight years have passed since the 1980 census data, from which t h e s e conclusions were
drawn, b e c a m e available. Naturally, one wonders whether or not t h e s e patterns persisted in
the 1980s and if they intensified or abated. The
answers to t h e s e q u e s t i o n s were r e c o r d e d
when the Census of Population was taken in the
spring and summer. However, as mentioned
above, the process of tallying and refining the
statistics will take several years. Meanwhile the
other sources of migration information discussed in this article can paint a preliminary picture of s o u t h e r n migration t r e n d s as they
developed in the 1980s.
What r e c e n t CPS interregional d a t a indicate. The net migration gain by the 16 states
plus the District of Columbia that make up the
Census South region slipped in the 1980s. 1 0
This increase declined from 1,986,000 p e o p l e in
the 1975-80 period to an estimated 1,898,000 in
the 1980-85 period. The yearly gain then dropped
to a margin of 35,000 from 1985 to 1986 (not
statistically significant) before rising to 279,000
b e t w e e n 1986 and 1987. Migration from the
I7
FEDERAL RESERVE B A N K O F ATLANTA
Northeast to the South slowed sharply in the
second half of the 1975-85 period, while outmigration from the Midwest to the South increased. Between 1980 and 1985, for the first
time ever, the South registered a net gain (roughly 60,000) from population exchange with the
West. Over the next two years the South resumed its loss in exchange of residents with the
West, but it continued to gain from the Northeast. It lost 117,000 in population exchange with
the Midwest in the 1985-86 period but gained a
similar number from 1986 to 1987.
It is not the purpose of this article to explain
why these and other migration patterns emerged
or changed. 1 1 Nevertheless, the broad changes
noted are consistent with major shifts in national e c o n o m i c and demographic determinants of migration flows. For example, as the
large baby-boom generation ages, passing the
time when they are most likely to migrate, population movement is slowing nationally. Also, as
strengths and weaknesses have shifted from
o n e e c o n o m i c s e c t o r to another, s t a t e s and
regions most d e p e n d e n t on particular industries such a s energy or manufacturing have
experienced attendant transitions in migration
patterns.
Net migration by blacks to the South also
d r o p p e d b e t w e e n t h e 1975-80 and 1980-85
periods—from 108,000 to 84,000, or by about
one-fifth. This percentage drop was much larger
than the 4 percent decline for whites. However,
the black n e t migration rate apparently has
begun rising again in the 1985-90 period. The
S o u t h s net addition of blacks was 18,000 b e tween 1985 and 1986 and 148,000 from 1986 to
1987. Black n e t migration a c c o u n t e d for over
half t h e region's total migration gain during
t h e s e two years.
What C o m p o n e n t s of Population Change
migration d a t a reveal. Migration patterns in
several southern states have shifted markedly
between the 1970s and the 1980s (see Table 2).
The Components of Population Change data
indicate that the South had gained an estimated 1.2 million fewer p e o p l e from migration
in the 1980s in the period up to nine months
before the 1990 Census was taken. Maryland,
Virginia, North Carolina, and Georgia posted
sharp increases, and all of the Atlantic coastal
states gained population from migration in the
1980s. However, five states—West Virginia, Ken34
tucky, Mississippi, Oklahoma, and L o u i s i a n a experienced net outmigration during the 1980s
after posting net gains in the 1970s.
Examination of net migration yearly estimates for southern states reveals that sharp
declines developed among energy-dependent
states as oil prices dropped. Texas, for example,
started the d e c a d e with a net migration gain of
431,000 in 1981 -82 but lost 122,000 residents to
outmigration in 1987-88. Net migration a d d e d
91,000 residents to Oklahoma between 1981
and 1982, whereas 55,000 p e o p l e moved out
from 1986 to 1987. Housing and office markets in
t h e s e and other states plunged as the previously positive net migration stream reversed
direction.
Louisiana, the most energy-dependent southeastern state, experienced a shift in net migration from a 36,000 gain between 1981 and 1982
to an 89,000 loss from 1986 to 1987. T h e outflow
apparently then stabilized, as losses held to
78,000 and 64,000 in the 1987-88 and 1988-89
periods, respectively. Altogether, between July
1983 and July 1989 Louisiana lost 308,000 people from migration, or 7 percent of its 1980 population base.
Other southeastern states have had different
migration experiences, according to the Components of Population Change data. The population influx to Florida and Georgia, which had
b e e n fairly strong from 1980 to 1983, accelerated
significantly in the July 1983-July 1987 period.
Net inmigration then d r o p p e d s o m e w h a t in
Florida and even more in Georgia over the next
two years. 1 2 T e n n e s s e e ' s pattern was similar to
Florida's and Georgia's but much smaller in
magnitude. Alabama's net migration reversed
twice in the 1980s, with gains posted in the 198387 period and losses at the beginning and end
of the d e c a d e . However, the yearly figures for
net migration over the d e c a d e in Alabama were
small, ranging only from -10,000 to +11,000. Mississippi experienced net outmigration throughout the d e c a d e and especially during the last
three years.
What IRS d a t a show. Yearly p a t t e r n s of
southeastern migration in the 1980s shown by
the Internal Revenue Service data are similar to
those indicated by the Components of Population Change data. However, IRS statistics reveal
s o m e additional information about state-tostate flows (see Table 3):
E C O N O M I C R E V I E W , M A R C H / A P R I L 1990
Table 2.
Southern Net Migration
(in thousands)
April 1970April 1980
West Virginia
Maryland
Monthly
Average
April 1980July 1989
Monthly
Average
71
0.59
-143
-1.29
-36
-0.30
187
1.68
-6
-0.05
40
0.36
-164
-1.37
-60
-0.54
Virginia
239
1.99
377
3.40
North Carolina
278
2.32
351
3.16
South Carolina
210
1.75
159
1.43
Georgia
329
2.74
526
4.74
Delaware
District of Columbia
Florida
South Atlantic
2,519
20.99
2,549
22.96
3,440
28.67
3,986
35.91
-1.05
Kentucky
131
1.09
-117
Tennessee
297
2.48
122
1.10
97
0.81
8
0.07
Alabama
31
0.26
-82
-0.74
East South Central
556
4.63
-69
-0.62
-0.14
Mississippi
Oklahoma
230
1.92
-16
Arkansas
184
1.53
14
0.13
Louisiana
100
0.83
-226
-2.03
Texas
1,481
12.34
1,087
9.79
West South Central
1,995
16.63
859
7.75
South Total
5,991
49.93
4,776
43.04
Source: Computed by Federal Reserve Bank of Atlanta from Bureau of the Census, U.S. Department of Commerce, Components of Population Change, series P-25, various years.
Alabama. At t h e beginning of t h e d e c a d e
Florida, Texas, and Louisiana were t h e t h r e e
largest gainers from e x c h a n g e with Alabama.
Toward t h e e n d of t h e d e c a d e , though, Georgia
and T e n n e s s e e had r e p l a c e d t h e two energyd e p e n d e n t s t a t e s as t h e biggest gainers from
Alabama. In a startling turnaround Louisiana
actually lost m o r e from migration e x c h a n g e with
Alabama than all but o n e other state. It is likely
that many of t h o s e who moved to Alabama from
Louisiana were return migrants who had lost
their j o b s in Louisiana's d e p r e s s e d economy.
Florida. Texas was t h e biggest gainer from
migration e x c h a n g e with Florida at t h e begin-
ning of t h e d e c a d e but b e c a m e a net l o s e r when
t h e price of oil started to drop in 1982. New York
consistently ranked as t h e biggest contributor
to Florida's migration gain, b u t several other
large northern s t a t e s c o n t r i b u t e d significant
n u m b e r s too. When Floridians left t h e state,
they were m o s t likely to g o to Georgia, which
drew m o r e and m o r e of its southern neighbors
as t h e d e c a d e progressed.
Georgia. Indeed, t h e biggest contributors t o
Georgia's yearly net migration gain switched
during t h e d e c a d e from Michigan to Florida.
Generally, though, Georgia gained population
from e x c h a n g e with its southern neighbors and
I7
FEDERAL RESERVE BANK O F ATLANTA
Table 3.
Southeastern States' Net Migration Exchange*
State
Alabama
Florida
Georgia
Louisiana
Mississippi
1980-81
1981-82
1982-83
1984-85
1985-86
-2,948
-2,906
-532
GA
FL
NC
-3,733
-2,429
-498
GA
FL
TN
-3,858
-1,283
-168
692
732
1,185
LA
MS
IL
894
1,153
1,395
MS
LA
IL
1,265
1,666
1,838
GA
NC
AZ
-3,619
-1,326
-209
GA
NC
DC
-4,619
-1,997
-310
GA
NC
AZ
-7,279
-1,550
-177
20,425
20,500
32,407
MI
OH
NY
18,269
22,358
36,573
IL
OH
NY
17,685
21,826
37,450
NJ
OH
NY
23,666
25,981
56,631
TX
HI
AK
-290
-282
-258
DC
MT
ND
-69
-43
-27
-14
-8
DC
AK
-32
-20
2,360
2,684
2,951
MI
IL
OH
2,451
2,622
3,674
IL
FL
OH
3,194
3,619
4,321
TN
FL
OH
4,492
4,619
5,438
IL
OH
FL
5,384
6,398
7,279
-6,374
-1,090
-630
CA
TX
MS
-4,830
-1,424
-705
TX
FL
GA
-4,470
-2,095
-977
TX
FL
CA
-7,467
-2,963
-2,277
TX
FL
CA
-10,441
-3,378
-3,315
MI
AL
IL
2,262
2,290
2,300
MI
OH
IL
1,106
1,107
1,399
OH
IN
IL
462
491
587
MI
OK
IN
234
313
591
ND
IA
IN
97
156
222
-2,868
-1,624
-758
TX
LA
OK
-3,654
-1,349
-587
TX
FL
CA
-1,910
-962
-532
TX
FL
GA
-2,067
-1,491
-824
TX
GA
FL
-2,652
-1,511
-1,455
TX
FL
AL
-1,956
-1,641
1,265
602
661
1,230
AL
IN
TN
853
1,229
2,942
LA
TN
IL
705
1,134
1,152
IN
LA
IL
256
455
618
IN
IL
LA
333
671
1,756
TN
IL
LA
599
834
2,243
-4,029
-4,008
-1,792
TX
FL
LA
-6,398
-2,766
-2,290
FL
GA
TX
-2,374
-1,848
-1,639
OH
IL
Ml
764
1,072
1,611
IL
TN
MI
1,074
1,180
1,216
IN
IL
MI
740
965
1,900
TX
GA
LA
-7,078
-1,909
-1,556
TX
GA
CA
-11,835
-2,038
-1,522
GA
NC
TX
-2,422
-1,382
-995
Ml
OH
NY
20,490
20,781
48,320
OH
MI
NY
21,347
21,735
40,307
OH
MI
NY
TX
LA
AZ
-2,430
-752
-284
TX
LA
OK
-4,050
-842
-603
NY
OH
MI
2,792
2,824
3,050
NY
Ml
OH
TX
CO
OK
-4,027
-461
-203
TX
OK
CO
MI
AR
AL
1,728
1,729
1,792
TX
LA
FL
MI
TN
IL
FL
TX
LA
1983-84
GA
FL
NC
Ml
IN
IL
Hl
VT
—
—
—
—
continued on next page
from the large northern states. Between 1984
and 1985 Georgia posted net losses only with
Hawaii (14 people) and Vermont (8) and t h e s e
were not statistically significant; from 1985 to
1986 the only losses were with the District of
Columbia (32) and Alaska (20). The Peach State's
experience with Texas has b e e n similar to that
of Florida, losing population at the beginning of
the d e c a d e and then gaining later.
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Louisiana. T h e Pelican S t a t e started the
d e c a d e with net losses to only eight states; by
1985-86, it was a net gainer with only ten states,
and its biggest gain was only 222 p e o p l e with
Indiana. Typically, Texas drew more Louisiana
residents than any other states; its gain rose
from 4,000 in 1980-81 to over 10,000 in 1985-86.
Mississippi. About as many states lost population to Mississippi as gained from it. However,
net outmigration to states like Florida, Texas,
Alabama, and Georgia e x c e e d e d its largest
gains from other states. Interestingly, Louisiana
was the second biggest gainer with Mississippi
between 1980 and 1981 at 1,624 but the biggest
contributor (2,243) to Mississippi's gain from
1985 to 1986. Like Alabamians, s o m e of t h e s e
migrants undoubtedly were returning to their
state of birth after having b e e n lured to Louisiana during the energy boom of the 1970s.
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Tennessee. The Volunteer State has consistently contributed population to Florida and
Georgia while gaining from Michigan, Illinois,
Ohio, and Kentucky. On balance, the number of
states from which T e n n e s s e e has b e e n a net
gainer increased during the 1980s. However,
migration d o e s not appear to have b e e n nearly
as important a phenomenon in T e n n e s s e e as it
has b e e n in Florida and Georgia (positively), or
Louisiana (negatively).
What moving company shipments d a t a suggest. Allied's headline on its 1989 data r e l e a s e
reads, "Allied Van Lines' 'Magnet States' Survey
Confirms U.S. Mobility Patterns toward U.S.
Coastlines." United's headline states: "Oregon,
Pacific Northwest Area Lead United Van Lines'
1989 Migration Patterns Study." Both releases
discuss details of states' 1989 experiences, describing a similar, though not identical, picture
of migration streams. (See the map on page 38
for a visual summary of combined Allied Van
Lines and United Van Lines shipment data.)
If accurate, t h e s e data provide encouraging
news to southeastern states (see Table 4). For
I7
FEDERAL RESERVE B A N K O F ATLANTA
Map.
Moving Company Shipments (Allied Van Lines and United Van Lines)
(percentage inbound for selected states)
66.2 D.C.
Top Ten Inbound
Bottom Ten Inbound
Source: S e e Table 1.
Table 4.
Combined Moving Company Shipments Net Migration Estimates
State
1983
1984
1985
1986
1987
1988
1989
Alabama
-221
-195
-290
432
395
420
456
Florida
8,465
9,237
9,846
9,944
10,462
8,875
9,561
Georgia
2,678
3,894
4,180
4,086
3,755
2,745
2,708
-1,096
Louisiana
182
56
-760
-1,661
-1,577
-959
Mississippi
-97
-202
-241
-124
-319
-270
-209
Tennessee
169
225
303
1,448
1,815
914
1,143
Southeast
11,176
13,015
13,038
14,125
14,531
11,725
12,563
Source: C o m p u t e d b y Federal Reserve B a n k of Atlanta f r o m Allied Van Lines, Inc., a n d United Van Lines, Inc., data.
Alabama net outmigration in t h e 1983-85 period
gave way to net inmigration in each of t h e next
four years. Florida and Georgia both e n j o y e d
rising net inmigration in t h e 1983-86 period and
then diminishing population inflows over t h e
next two years; n e t inmigration may have sta38
bilized in Georgia during 1989 and r e s u m e d its
growth in Florida. Net outmigration from Louisiana and Mississippi continued, b u t t h e amounts
d e c l i n e d in t h e 1988-89 period c o m p a r e d to
1987. Meanwhile, net inmigration to T e n n e s s e e
has b e e n higher in t h e 1986-89 period than it
ECONOMIC REVIEW, MARCH/APRIL 1990
was earlier in the 1980s. For the region as a
whole, migration gains i n c r e a s e d during the
1983-87 period, dropped in 1988, and stabilized
in 1989.
Directions for Future
Migration Research
As additional information about migration
b e c o m e s available from the intercensal sources
reviewed above and the 1990 Census of Population, several aspects of migration should elicit
further research. With more and b e t t e r information, policymakers and planners will probably
s e e k more accurate assessments of migration's
impacts on income, educational n e e d s , and
labor force skills. States that experienced reversals of migration patterns during t h e 1980s
should b e especially i n t e r e s t e d in such research since it appears that past planning was
often b a s e d on simple extrapolations and the
implicit assumption that current economic conditions, particularly prosperity induced by high
oil prices, would continue indefinitely, as would
inmigration. In addition, future research ought
to p r o b e the determinants of migration, including the effect on migration decisions of employment opportunities (or the lack thereof) and
other economic conditions in both the sending
and receiving areas.
Conclusions
This survey of the various data series on U.S.
migration and review of what the data indicate
about southeastern migration is revealing. First, a
surprising amount of statistical information is
available between the detailed decennial
censuses—probably the b e s t source of information. A review of t h e alternative intercensal
series indicates that each o n e offers certain
advantages. The Current Population Survey data
give the most detail about movements of major
population groups, such as blacks, from one
large region of the country to another. Components of Population Change estimates are
c o m p r e h e n s i v e and fairly current. Internal
Revenue Service data offer place-to-place migration estimates, and moving company shipm e n t s data provide t h e m o s t current direct
estimates of interstate migration.
Against the backdrop of information from the
1970 and 1980 Censuses of Population, t h e s e
sources indicate several significant changes in
s o u t h e a s t e r n migration patterns during t h e
past d e c a d e . The Southeast continued to gain
population from net inmigration. Florida and
Georgia registered an acceleration from already
strong levels. T e n n e s s e e ' s gains were positive,
and Alabama's performance, though mixed,
s e e m e d to b e strengthening at the end of the
decade. In contrast, Louisiana and Mississippi
suffered significant migration losses during the
1980s, though improvement s e e m e d evident in
the past few years.
The d e c a d e of the 1990s is sure to bring new
surprises. As events unfold and state economies strengthen or weaken in response, migration patterns will continue to change. With new
insights into the causes and c o n s e q u e n c e s of
migration b a s e d on solid empirical tests using
the extensive data available from this year's
census, the burdens and benefits of swelling
and sharply receding migration streams can b e
managed better.
I7
FEDERAL RESERVE B A N K O F ATLANTA
Notes
1
In a nation of 250 million people who are highly mobile,
census takers are bound to miss some people. Based on
post-1980 census surveys and reviews of vital statistics,
the Census Bureau estimates that the U.S. population on
April 1, 1980, was 1.4 percent higher than the 226.5 million
it reported. The undercount for 1970 was estimated at 2.9
percent; in 1960 it was 3.3 percent.
2
See, for example, J.D. Kasarda, M.D. Irwin, and H.L. Hughes,
"The South is Still Rising," American Demographics 8
()une 1986): 33-40. Other research, reviewed by M.). Greenwood in " H u m a n Migration: Theory, Models, and Empirical Studies," journal of Regional Science 25, no. 4
(1985): 521-45, suggests that more is known about the
determinants of migration than about its consequences,
but that even the causal linkages have not yet b e e n
well established.
t h r o u g h o u t this article Southeast refers to these six
states, which are wholly or partly in the Sixth Federal
Reserve District.
4
Larry Long, Migration and Residential Mobility in the
United States (New York: Russell Sage Foundation, 1988),
284. The Census Bureau has published three components
of population change for states during the decade of the
1970s: net migration, natural increase, and "error of
closure." The last represents the difference between the
Census Bureau's Components of Population Change estimate for April 1, 1980, and the 1980 Census of Population
count. It amounted to over 4.7 million persons for the
nation. These estimates appear in Bureau of the Census,
Estimates of the Population of States: 1970 to 1983,
Current Population Reports, series P-25, no. 957 (Washington, D.C.: U.S. Government Printing Office, 1984).
5
The Census Bureau p o i n t s out in an a p p e n d i x to its
Geographic Mobility that two other current surveys conducted by the bureau give additional migration information. The American Housing Survey, conducted since 1973,
contains residential m o b i l i t y data for selected metro
areas, and the Survey of Income and Program Participation, begun in 1984, is a series of annual panel surveys of a
40
national sample of individuals who are reinterviewed
every four months for a period of two and a half years.
6
Both of these methodologies are quite complex. A more
detailed description of the estimating methodologies can
be found in the Census Bureaus's Current
Population
Reports, series P-25, no. 957.
I
7
This statement is stamped on the unpublished table on
yearly residual migration that the Census Bureau sends to
researchers upon request.
8
Detailed information on processing the IRS data can be
obtained in an unpublished Census Bureau document
titled Use of Federal Tax Returns in the Bureau of the Census, Population Estimates and Projections Program.
9
F o r a detailed discussion of changing southern migration
patterns, see William ). Kahley, "Migration: Changing
Faces of the South," Federal Reserve Bank of Atlanta
Economic Review 67 (June 1982): 32-42.
^The states are Delaware, Maryland, Virginia, West Virginia,
North Carolina, South Carolina, Georgia, Florida, Kentucky, Tennessee, Alabama, Mississippi, Arkansas, Louisiana, Oklahoma, and Texas.
II
For a detailed discussion and explanation, and also for
projections of southern migration in t h e 1990s, see
William ). Kahley, "interregional Migration: Boon or Bane
for the South?" Federal Reserve Bank of Atlanta Economic
Review 74 (lanuary/February 1989): 18-34.
12
State agencies and some state-affiliated institutions, such
as the Bureau of Business and Economic Research (BBER)
at the University of Florida, also produce migration estimates. These are prepared using similar techniques. For
Florida in the 1980s, estimates prepared by the BBER
show a pattern similar to that shown by the Census
Bureau's Components of Population Change data. However, the BBER migration estimates have been 50,00055,000 higher over the past several years. BBER estimates
for the 1980s, in thousands, are as follows: 1980,476; 1981,
333; 1982, 237; 1983, 181; 1984-85, 609; 1986, 336; 1987,
341; 1988, 327; and 1989, 326.
E C O N O M I C R E V I E W , M A R C H / A P R I L 1990
Book Review
The Separation of Commercial and Investment Banking:
The Glass-Steagall Act Revisited and Reconsidered
by George ). Benston.
New York: Oxford University Press, 1990.
(Also published in England by The Macmillan Press, London, 1990.)
272 pages. $29.95.
o n g r e s s p a s s e d t h e Banking Act of
1933 to r e s t o r e o r d e r to t h e b a n k i n g
industry in t h e wake of financial distress during t h e late 1920s and early 1930s. T h e
portion of t h e law authored by S e n a t o r Carter
G l a s s a n d R e p r e s e n t a t i v e Henry S t e a g a l l —
widely referred to as " t h e Glass-Steagall Act"—
limited commercial banks' participation in t h e
securities b u s i n e s s . T i e s b e t w e e n c o m m e r c i a l
and investment banking had allegedly led t o
such a b u s i v e b a n k p r a c t i c e s a s granting unsound loans to shore up investment affiliates,
pressuring c u s t o m e r s to invest in securities, and
investing in excessively risky long-term securities.
C
During t h e 1980s c o m m e r c i a l b a n k s h a v e
urged regulatory a g e n c i e s and t h e c o u r t s t o
i n t e r p r e t G l a s s - S t e a g a l l l e s s stringently and
have l o b b i e d Congress to repeal t h e act. On t h e
other hand, trade groups representing t h e s e curities and investment industries have fiercely
c o n t e s t e d a t t e m p t s to relax restrictions or rescind t h e act. They argue that permitting banks
additional securities powers would invite a repetition of t h e p r o b l e m s of t h e 1920s and 1930s.
O p p o n e n t s of Glass-Steagall have c o u n t e r e d
t h a t t h e r e is no e v i d e n c e t h a t c o m m e r c i a l
banks' securities affiliates c a u s e d t h e c o l l a p s e
of t h e banking system. While acknowledging
that numerous other a b u s e s occurred during
t h e 1920s, banks point out that most of t h e s e
q u e s t i o n a b l e practices were legal at that t i m e
but are now illegal. In a r e c e n t turnaround, t h e
Securities Industry Association (SIA) e n d o r s e d a
plan to allow commercial banking organizations
to expand their securities activities (see Robert
G u e n t h e r 1989). Congress, however, a p p e a r s
unlikely to repeal Glass-Steagall promptly.
G e o r g e J. Benston s t e p s into t h e m i d d l e of
this d e b a t e with his latest book, The Separation
of Commercial
and Investment
Banking:
The
Glass-Steagall Act Revisited and
Reconsidered,
which c o n s i d e r s a variety of arguments for and
against revising or repealing Glass-Steagall. T h e
b o o k ' s main contribution is its careful reexamination of t h e 1930s' congressional record to
a s s e s s t h e e v i d e n c e of alleged bank a b u s e s
during that period. Benston—John H. Harland
Professor of Finance, Accounting, and Economics at Emory University in Atlanta—rejects almost all claims of a b u s e a s not being s u p p o r t e d
by specific e x a m p l e s or empirical evidence. T h e
I7
FEDERAL RESERVE BANK O F ATLANTA
b o o k a l s o reviews c o n t e m p o r a r y a r g u m e n t s
against granting additional security powers, inc l u d i n g c l a i m s that b a n k s ' security affiliates
would exploit federal protection of commercial
banks. An appendix reprints a survey by William
M. Isaac and Melanie L. Fein (1988) of permiss i b l e security activities carried out by banking
organizations.
Sources of Information
Many r e c e n t analyses of Glass-Steagall c i t e
secondary s o u r c e s such a s Ferdinand Pecora
(1939) to d o c u m e n t a b u s e s prior t o t h e act.
Benston d e v o t e s an entire c h a p t e r to a discussion of s o u r c e s on a b u s e s in t h e 1920s, following
t h e r e f e r e n c e s of prior authors back to t h e original sources—six congressional hearings and reports, along with t h e Securities and Exchange
Commission's (1940) report, Study of Investment Trusts and Investment
Companies.
The
congressional r e f e r e n c e s are: (1) 1932 hearings
on foreign b o n d s a l e s held by t h e S e n a t e Comm i t t e e on Finance, (2) 1931 and 1932 hearings
held by S e n a t o r Glass b e f o r e a s u b c o m m i t t e e of
the S e n a t e Committee on Banking and Currency,
(3) t h e 1932 report of t h e Glass s u b c o m m i t t e e
hearings, (4) c o m m e n t s m a d e on t h e House and
S e n a t e floors during May 1932 and May 1933 as
r e p o r t e d in t h e Congressional
Record, (5) t h e
1933 and 1934 Stock Exchange Practices (SEP)
Hearings of t h e S e n a t e C o m m i t t e e on Banking
a n d Currency (frequently c a l l e d t h e P e c o r a
Hearings, after t h e c o m m i t t e e ' s c o u n s e l ) , a n d
(6) t h e 1934 report of t h e S E P Committee. He
also u s e s "scholarly articles and reports" that
provide analysis, especially of financial data.
Evidence That Securities Affiliates
Caused Bank Failures
T h e m o s t serious charge raised against commercial banks affiliated with securities firms in
t h e 1920s was that such l i n k a g e s l e d to t h e
c o l l a p s e of t h e banking system and thus contributed to t h e start of t h e Great Depression.
Benston e x a m i n e s this issue from several perspectives.
42
T h e Glass S u b c o m m i t t e e Hearings (1931,
1063-64) list a variety of ways in which b a n k s
can a d v e r s e l y affect their affiliates. B e n s t o n
n o t e s , though, that this o f t e n - c i t e d list refers
to potential p r o b l e m s and not necessarily to
ways in which b a n k s had actually b e e n endangered. A review of t h e hearings, Benston
claims, yields little e v i d e n c e that banks with
securities affiliates were m o r e likely to fail or
that they c a u s e d larger d e p o s i t o r l o s s e s when
they did fail. 1
O n e c a s e in which a bank clearly failed a s a
result of its affiliates was that of t h e Bank of t h e
United States. Its affiliates' primary purpose,
however, was to hold real e s t a t e ; t h e only s e curities affiliate that c a u s e d p r o b l e m s was engaged in buying t h e bank's stock. Furthermore,
two of t h e bank's l e a d e r s went to prison for
using b a n k a s s e t s for their personal gain. T h e
s o l e lesson to b e learned from t h e Bank of t h e
United S t a t e s ' failure, according t o Benston, is
that bank affiliates may b e used as a m e a n s of
hiding b a d loans from examiners. Prohibiting
banks from having securities affiliates, he points
out, cannot eliminate such practices.
Benston also e x a m i n e s t h e hypothesis that
large b a n k s ' s e c u r i t i e s a f f i l i a t e s d a m a g e d
smaller banks by pushing securities on them.
S e n a t o r Glass (Congressional Record
1932,
9887) a s s e r t e d that a significant portion of bank
failures was c a u s e d by small banks' investment
in long-term securities. B e n s t o n finds no support for this c h a r g e in t h e s u b c o m m i t t e e ' s
hearings. I n d e e d , in t h e few c a s e s in which
securities investments were discussed, t h e evid e n c e b e f o r e t h e s u b c o m m i t t e e s u g g e s t e d that
i n v e s t m e n t portfolios w e r e n o t a significant
c a u s e of failure.
Evidence That Banks
Committed Other Abuses
B e n s t o n c o n s i d e r s a variety of a l l e g a t i o n s
concerning abusive activities by banks' securities affiliates. Of t h e s e charges, t h o s e in t h e testimony of Charles E. Mitchell, p r e s i d e n t of
National City Bank, and Albert Wiggin, presid e n t of Chase National Bank, b e f o r e t h e Pecora
Hearings had t h e most influence on Congress's
decision to p a s s t h e Glass-Steagall Act. T h e s e
E C O N O M I C R E V I E W , M A R C H / A P R I L 1990
[
[
[
men ran t h e two largest banks in t h e United
S t a t e s at that t i m e . 2
Mitchell's a n d Wiggjn's testimony. B e n s t o n
evaluates various authors' claims that Mitchell's
and W i g g i n s testimony at t h e Pecora hearings
e x p o s e d a variety of a b u s e s . He remarks that,
although many of t h e s e alleged a b u s e s are not
relevant to t h e separation of commercial and
investment banking, they e n g e n d e r e d significant public r e s e n t m e n t in 1933, when t h e country was still in t h e throes of d e p r e s s i o n . S o m e of
the q u e s t i o n a b l e practices not a d d r e s s e d by
Glass-Steagall were excessive salaries and
b o n u s e s as well as tax avoidance and, in s o m e
c a s e s , p o s s i b l e tax evasion.
Other charges raised at t h e hearings relate to
p r o b l e m s that are potentially serious but not
unique to commercial banks' investment affiliates, according to Benston. Moreover, B e n s t o n
claims, a careful scrutiny of t h e record reveals
most of t h e s e charges are not s u p p o r t e d . For
example, Vincent Carosso (1970,330-31) a l l e g e s
that National City Corporation (the investment
affiliate of National City Bank) sold bonds issued
by Minas G e r a e s (a Brazilian state, now Minas
Gerais) with i n a d e q u a t e disclosure. O n e s p e cific allegation is that National City withheld
particularly d a m a g i n g information a b o u t t h e
s t a t e uncovered by o n e of t h e corporation's
officials. B e n s t o n reports that this information
c o n s i s t e d merely of a description of conditions
under former l e a d e r s of Minas G e r a e s at least 10
years b e f o r e t h e s t a t e issued t h e b o n d s .
S o m e of t h e alleged a b u s e s r e p o r t e d at t h e
Pecora Hearings are unique to securities firms
affiliated with commercial banks. If substantiated, t h e s e charges might justify legislation
banning any relationship b e t w e e n t h e two types
of financial firms. Yet, after careful examination,
Benston c o n c l u d e s that t h e accusations fail to
s u p p o r t G l a s s - S t e a g a l l r e s t r i c t i o n s . For instance, Benston c o n s i d e r s Carosso's (1970, 333)
allegation t h a t National City Bank sold b a d
loans to its investment affiliate in an a t t e m p t to
disguise bad banking practices from t h e bank's
shareholders. This charge would b e serious if
the b a n k had u s e d t h e s a l e to hide t h e l o s s e s
from bank examiners, but Carosso acknowledges
that e x a m i n e r s had previously criticized t h e
loans. Furthermore, Benston states, t h e bank's
shareholders had b e e n informed a b o u t t h e loan
b e f o r e its sale. Although t h e bank did not notify
s h a r e h o l d e r s of t h e sale, t h e sale itself had no
effect on t h e value of their shares. An owner of a
given p e r c e n t a g e of National City Bank s h a r e s
was required to own t h e s a m e p e r c e n t a g e of
National City Corporation. National City mana g e m e n t claims that it m a d e t h e transfer to
increase t h e bank's portfolio's liquidity. In any
c a s e , m a n a g e m e n t thought t h e loans were g o o d
at t h e time of t h e transfer.
Trust D e p a r t m e n t s and Affiliated Investm e n t Companies. A final area of a l l e g e d a b u s e
that Glass-Steagall purported to correct was t h e
c o n f l i c t s of i n t e r e s t t h a t c o m m e r c i a l b a n k s
affiliated with securities and investment firms
may e x p e r i e n c e . David Silver (1987) alleges numerous a b u s e s by b a n k - s p o n s o r e d investment
c o m p a n i e s . Tracing Silver's r e f e r e n c e s to supporting e v i d e n c e from t h e SEC Reports (1940,
1942), Benston d i s p u t e s s o m e of Silver's allegations but c o n c e d e s that s o m e e v i d e n c e exists to
support other charges. In particular, Benston
finds that b a n k s occasionally u s e d investment
company funds to support activities of special
value, such a s purchasing b a n k loans. Such
activities by b a n k - s p o n s o r e d investment c o m p a n i e s could c a u s e substantial l o s s e s to investors if banks forced t h e investment c o m p a n i e s
to purchase a s s e t s at above-market values.
Benston finds no e v i d e n c e , however, that t h e s e
practices resulted in l o s s e s to investment c o m p a n i e s or their shareholders. Moreover, he argues, t h e SEC Reports found far m o r e a b u s e s
involving i n d e p e n d e n t investment c o m p a n i e s
than among b a n k - s p o n s o r e d c o m p a n i e s .
B e n s t o n a l s o d i s p u t e s o t h e r e v i d e n c e of
a b u s e s involving investment affiliates, such as a
U.S. S u p r e m e Court s t a t e m e n t in Investment
Company Institute v. Camp (401 U.S. 617, 633
|1971|): "Congress had b e f o r e it evidence that
security affiliates might b e driven to unload
e x c e s s i v e holdings through t h e trust departm e n t of t h e s p o n s o r b a n k . " (The e m p h a s i s is
B e n s t o n ' s . ) Although t h e h e a r i n g s p r o d u c e d
e v i d e n c e that o n e trust d e p a r t m e n t b o u g h t
securities from its affiliate and that s o m e other
trust d e p a r t m e n t s may have m a d e such purc h a s e s , Benston says t h e record also suggests
that m o s t b a n k s did not buy securities from
their affiliates. Furthermore, B e n s t o n ' s review
uncovered no e v i d e n c e that investment affilia t e s " u n l o a d e d " securities on trusts at a b o v e market prices.
I7
FEDERAL RESERVE B A N K O F ATLANTA
While B e n s t o n ' s analysis to this point appears sound, his evaluation of banks' investm e n t affiliates suffers from two minor weakn e s s e s . First, a careful reading of t h e S u p r e m e
Court's opinion and Benston's analysis shows
that t h e two are not necessarily in conflict. T h e
court referred to e v i d e n c e that securities affiliates "might b e driven to unload" (emphasis
added) securities on t h e trust affiliate. T h e court
did not claim to have e v i d e n c e that such an
action had occurred.
S e c o n d , B e n s t o n c i t e s e v i d e n c e suggesting
that investment affiliates in general, and City
Bank Farmers Trust in particular, did not buy
securities from their affiliates. However, evid e n c e not cited by B e n s t o n suggests that City
Bank Farmers Trust Company, affiliated with
National City Bank, may have bought securities
from National City Corporation, t h e bank's s e curities affiliate. Carosso (1970, 332) n o t e s that
Mitchell t e s t i f i e d at t h e Branch, Chain, and
Group Banking Hearings (1930) that National
City's trust affiliate would not buy from t h e
securities affiliate without e x p r e s s permission
from t h e maker. Mitchell (p. 1972 of t h e hearings) s t a t e d , however, that individuals who
sought a trust a g r e e m e n t were shown " t h e advantages" of granting permission. This testimony i m p l i e s that s o m e trusts m a d e purc h a s e s from t h e investment affiliate, but t h e
implications are never directly a d d r e s s e d at
t h e s e hearings. In t h e G l a s s S u b c o m m i t t e e
Hearings (1931), as q u o t e d by Benston, Mitchell
testified that t h e trust affiliates' policies prohibited purchases through the investment affiliate, e v e n if such purchases were authorized
by t h e trust a g r e e m e n t . Nonetheless, a careful
review of t h e s e hearings d o e s not indicate when
this policy took effect. Thus, contrary to Benston's conclusions, t h e record neither confirms
nor disproves t h e trust affiliate's purchase of
securities from National City's investment affiliate.
Overproduction of
Financial Securities
Aside from bank failures and abusive practices s u p p o s e d l y e n g e n d e r e d by t h e affiliation
of commercial and investment banking, s o m e
44
p r o p o n e n t s of G l a s s - S t e a g a l l b e l i e v e d that
such r e l a t i o n s h i p s would n e c e s s a r i l y c a u s e
commercial bankers to relax their normal caution. Benston e x p l o r e s this argument a s d e v e l o p e d by S e n a t o r Bulkley in a frequently c i t e d
1932 s p e e c h . 3 Bulkley claimed that b a n k s m a d e
excessive margin loans to support their securities affiliates and that investment banking affiliates encouraged overproduction of securit i e s to k e e p t h e i r s a l e s f o r c e s busy. T h e s e
c h a r g e s s u g g e s t that c o m m e r c i a l b a n k s and
their securities affiliates contributed to t h e 1929
stock market crash by increasing alreadyexcessive speculation during t h e 1920s through
t h e excessive u s e of margin loans and t h e sale of
q u e s t i o n a b l e securities.
B e n s t o n n o t e s that s u b s e q u e n t e c o n o m i c
analysis d o e s not support Bulkley's claim that
s p e c u l a t i o n f u e l e d by b a n k margin l e n d i n g
c a u s e d or increased t h e severity of t h e D e p r e s sion. He a l s o p o i n t s out that G l a s s - S t e a g a l l
d o e s not prohibit banks from making margin
loans. Benston a d d s that e c o n o m i c activity and
s e c u r i t i e s underwriting r e m a i n e d d e p r e s s e d
long after bank securities affiliates were eliminated.
If S e n a t o r Bulkley's s e c o n d charge were valid,
then returns on bank-underwritten securities
should have b e e n significantly worse than returns on securities underwritten by other firms,
according to Benston. He n o t e s that exact c o m parison is difficult b e c a u s e t h e relevant returns
are t h e u n o b s e r v a b l e ex a n t e e x p e c t e d distribution of returns rather than t h e o b s e r v e d ex
post realized returns. However, c o n c e d i n g this
l i m i t a t i o n , B e n s t o n c i t e s s t u d i e s by Terris
Moore (1934) and G e o r g e Edwards (1942), both
of which suggest that issues originated by c o m mercial b a n k s ' affiliates actually had slightly
b e t t e r ex post returns than issues from indep e n d e n t organizations.
Explanations for the
Passage of Glass-Steagall
Given that B e n s t o n ' s analysis suggests little
e c o n o m i c rationale for t h e adoption of GlassSteagall, t h e q u e s t i o n arises a s to why t h e act
was p a s s e d . In c h a p t e r 6 B e n s t o n d e v e l o p s t h e
hypothesis that t h e act resulted from a c o m E C O N O M I C R E V I E W , M A R C H / A P R I L 1990
[
bination of s p e c i a l i n t e r e s t trade-offs and
banks' desire to avoid even worse legislation.
Chapter 11 reviews a number of other factors
that may have contributed to the passage of
the act.
Chapter 6 reports that banks' securities affiliates were increasing their share of the new
issue market in the 1920s, originating over 50
percent of new bonds in 1929. Benston (pp. 13435) attributes this growing market share to two
factors: (1) banks' "apparent positive reputations among their customers, which provided
them with goodwill that they could transfer to
securities products" and (2) economies of scale
and s c o p e that could b e realized by combining
commercial and investment banking. Bank affiliates' gain in market share provided unaffiliated securities firms with a strong incentive
to s e e k a legislative ban on affiliation.
Benston discusses Jonathan R. Macey's (1984)
argument that, since Glass-Steagall could not
b e justified on the basis of its public benefits,
the actual motive behind the act must have
b e e n to protect special interests. Benston is
sympathetic to Macey's proposal but suggests
that commercial banks had several reasons for
not resisting the legislation. First, banks' securities affiliates had b e c o m e unprofitable by
1933. In addition, banks were already dealing
with public outrage resulting from the large
number of bank failures, the losses on investments made through bank securities firms, and
the charges of wrongdoing by bankers, e s p e cially by Charles Mitchell. In fact, Benston avers,
Winthrop W. Aldrich, the new p r e s i d e n t of
Chase National Bank, probably lent support to
Glass-Steagall to d i s t a n c e himself and the
Rockefeller interests from the controversial activities of Chase's prior administration.
S o m e of the explanations offered by Benston
may h e l p to explain t h e p a s s a g e of GlassSteagall. However, Macey's claim that specialinterest theory must b e true b e c a u s e the publ ic
did not benefit from the act is weak even if one is
skeptical of the public interest justifications.
The relevant issue, which is not discussed by
Benston, is whether Congress believed GlassSteagall to b e in the public interest, not whether
it actually was. The available evidence from congressional s p e e c h e s and newspaper editorials
suggests that many believed that the act was
indeed in the public interest. 4
Chapter 11 begins with a discussion of Senator Glass's long-held beliefs that banks' loans
should b e limited to businesses' short-term
credit n e e d s and that margin lending was a perversion of the banking system. Along with this
explanation, Benston considers the failure of
the Bank of the United States as well as the
banking system's collapse in the early 1930s as
reasons for eliminating bank securities affiliates
and "punishing" banks.
A structural weakness of the book is chapter
11 's recap of the reasons for passage of GlassSteagall presented in chapter 6. The division of
explanations into two widely separated chapters interrupts t h e flow of the argument and
causes an unnecessary repetition of material.
A more serious problem for the book is that
s o m e of its explanations for t h e p a s s a g e of
Glass-Steagall may b e construed as providing
ammunition for those o p p o s e d to repealing the
act. B e n s t o n , a strong a d v o c a t e for repeal,
s e e m s not to recognize this problem. He argues
that bank affiliates benefited from the public's
c o n f i d e n c e in banks, which had maintained
good service records. Consumers s e e m to have
felt that bank affiliates would give better or at
least more conservative investment advice than
independent firms. Banks and affiliates used
this goodwill to boost their market share in the
1920s. Whatever e d g e affiliates may have had,
they were unable to offset the magnitude of the
1929 market crash. Yet the public appears to
have judged banks and their affiliates harshly
after the crash b e c a u s e of unrealistic expectations of their investment prowess.
Today's proponents of Glass-Steagall cite the
public's overconfidence in bank affiliates' investment advice in the 1920s as justification for
banning bank securities affiliates. Supporters of
the act argue that consumers will suspend normal caution toward new investments if they are
recommended by banks and will therefore b e
more likely to make inappropriate, excessively
risky investments.
While policymakers should consider ways to
reduce the risk that s o m e consumers will place
excessive confidence in banks' affiliates, this
issue d o e s not necessarily justify a ban on securities affiliates. A total ban would r e d u c e c o m petition among investment firms and eliminate
s o m e gains in c o n v e n i e n c e that c o n s u m e r s
would obtain from one-stop financial shopping.
I7
FEDERAL RESERVE B A N K O F ATLANTA
Furthermore, while s o m e consumers may place
unjustified confidence in their bank's securities
affiliate, several factors suggest that this problem would b e limited. Investors of the 1980s are
likely to b e more sophisticated than those of the
1920s due to the growth of business and financial reporting on television and in print media.
Thus, the proportion of investors who would
naively trust advice from a securities affiliate of
their bank has probably dropped significantly
since the 1920s. Additionally, experience will
teach consumers that the quality of investment
advice offered by banks is not necessarily superior to that offered by unaffiliated firms. 5
Moreover, bank affiliates may have a greater
incentive to maintain consumer goodwill than
unaffiliated firms. Unaffiliated firms that make
excessive promises to an individual risk losing
that individual's securities business. Bank affiliates that promise more than they can deliver
may lose not only an investor's securities busin e s s b u t also that person's accounts at t h e
affiliate bank. Benston would probably not disag r e e with any of t h e s e points, b u t his argument would have b e e n stronger had he dealt
with this issue directly.
Contemporary Justifications for
Glass-Steagall
Benston recognizes that other arguments
exist for continuing Glass-Steagall even if the
original rationale is questionable. O n e commonly raised objection to repeal is that allowing
banks to have securities affiliates would substantially increase the risks borne by the Federal Deposit Insurance Corporation (FDIC) and
the Federal Reserve System. This view holds
that securities activities are inherently riskier
than traditional commercial banking activities
and that risks incurred by o n e affiliate will
ultimately affect the operations of the entire
banking organization. Moreover, according to
current Glass-Steagall proponents, the government, through the FDIC and Federal Reserve,
would bear most of the losses associated with
the bank affiliates' failure.
While c o n c e d i n g that d e p o s i t insurance
should b e reformed b e c a u s e it creates a moral
hazard problem—encouraging bankers to take
46
on more risk b e c a u s e insurance limits the potential losses to depositors—Benston provides
several arguments suggesting that securities
affiliates will not substantially increase the risk
borne by the government. The Federal Reserve,
he claims, already provides a safety n e t for
securities markets, as demonstrated during the
October 1987 stock market crash, and banks
may already achieve any d e s i r e d risk level
through traditional commercial banking activities. Benston contends that securities activities
would not increase banks' risks except in circumstances involving inexperienced bankers
who do not fully appreciate the hazards inherent in activities. In fact, he observes, in the
1930s banks with securities affiliates had a failure rate significantly lower than that of banks
without affiliates.
Benston notes several studies that suggest
potential reductions in banks' risk due to diversification. 6 Other studies indicate that corporate stock underwriting is not particularly
risky. Though Benston admits that the effect
securities affiliates will have on commercial
banking is uncertain, he summarizes the evid e n c e as suggesting that "there is no reason to
b e l i e v e that banks would b e more likely to
b e c o m e insolvent" or place a greater strain on
the federal safety net. He also d o u b t s that
securities affiliates will make banks significantly
more profitable.
Proponents of Glass-Steagall contend that
bank-affiliated securities firms would constitute
unfair competition for independent firms b e cause deposit insurance would lower affiliates'
funding costs and their captive market would
provide ready customers on whom they could
unload securities. In response, Benston argues
that the relevant issue is not bank affiliates'
possible lower funding costs but the opportunity cost of using those funds, which is ind e p e n d e n t of deposit insurance. Countering
the argument that securities affiliates would
have captive markets in the affiliate bank, bankadministered trusts, and correspondent banks,
Benston asserts that securities affiliates which
overbid for securities will create losses for their
parent whether they sell the securities in the
market or to the bank. Hence, the p r e s e n c e of a
bank affiliate provides no incentive to overbid.
Bank-administered trusts would violate the law
if they purchased overpriced securities from
E C O N O M I C R E V I E W , M A R C H / A P R I L 1990
their affiliates. He also points out that securities
affiliates would not b e u n i q u e in facing p o t e n tial conflicts of interest. Many unaffiliated s e curities firms have mutual funds that can give
rise to t h e s a m e situation. Finally, he argues that
c o r r e s p o n d e n t banks would b e unlikely to unload overpriced securities on their r e s p o n d e n t
banks b e c a u s e t h e market is too competitive.
B e n s t o n also c o n s i d e r s t h e effect that repeal
of Glass-Steagall would have on banks' c o n c e n tration of power. T h e claim that repeal would
give t o o much power to banks is b a s e d on t h e
assumption that banks could u s e their trustadministered stock holdings plus any mutual
fund holdings to control nonfinancial firms.
B e n s t o n finds no e v i d e n c e that b a n k s h a v e
used their trust holdings to d o m i n a t e other corporations and s e e s no indications that securities privileges would b e u s e d manipulatively.
The e c o n o m i s t reviews a related argument—
that repeal of t h e act could r e d u c e concentration by expanding t h e limited n u m b e r of firms
that currently d o m i n a t e t h e underwriting of corporate securities. Benston finds t h e e v i d e n c e
on both s i d e s of this argument a m b i g u o u s and
suggests that t h e b e s t way to d e t e r m i n e t h e
effect of banks on t h e market is to repeal t h e act
and s e e what h a p p e n s . 7
T h e last i s s u e c o n s i d e r e d by B e n s t o n is
universal banking. Universal b a n k s can offer a
full range of financial services, may b e owned by
nonbanks, and can vote t h e s h a r e s of c o m p a n i e s whose stock they own. This c h a p t e r cons i d e r s t h e a r g u m e n t s for a n d a g a i n s t b o t h
specialized banking, as now m a n d a t e d in t h e
United States, and universal banking, a s practiced in West Germany. Benston c o n c l u d e s that
the substantial advantages universal banking
can provide would outweigh t h e few p r o b l e m s it
might c r e a t e for t h e economy.
Summary
An understanding of t h e merits of t h e GlassSteagall Act is important to Congress a s it considers whether to repeal or revise t h e act, and to
regulators and t h e courts as they interpret it.
T h e most important contribution of The Separation of Commercial
and Investment
Banking:
The Glass-Steagall
Act Revisited and Reconsidered is its thorough review of t h e d o c u m e n tation c o n c e r n i n g a l l e g e d a b u s e s by c o m mercial banks' securities affiliates during t h e
d e c a d e b e f o r e Glass-Steagall was e n a c t e d . No
future deliberation on e x p e c t e d a b u s e s if t h e
act is relaxed will b e c o m p l e t e unless it considers B e n s t o n ' s work. His discussion of contemporary issues in reforming Glass-Steagall is
largely a review of t h e existing literature, b u t it
provides valuable insights on t h e s e studies'
strengths and w e a k n e s s e s .
Perhaps t h e book's least valuable discussion,
certainly in t e r m s of t h e current d e b a t e on
Glass-Steagall, is its a t t e m p t t o explain why t h e
act was p a s s e d . Any discussion of this type is
necessarily speculative. Moreover, understanding t h e reasons for passing t h e act d o e s not
n e c e s s a r i l y h a v e much b e a r i n g on d e c i d i n g
what t h e b e s t policy would b e in t h e future.
Overall, however, B e n s t o n ' s b o o k s h o u l d b e
useful to policymakers in that it provides a careful review of t h e e v i d e n c e c o n s i d e r e d in e n a c t ing Glass-Steagall and a timely examination of
r e s e a r c h on this l e g i s l a t i o n ' s i m p a c t on t h e
banking industry.
Larry D. Wall
The reviewer is research officer in charge of the financial section of the Atlanta Fed's research department. He gratefully
acknowledges comments on the origin of Glass-Steagall by
Matthew Fink.
FEDERAL RESERVE B A N K O F ATLANTA
I7
Notes
'Benston cites further evidence from White (1986) that
securities operations were not responsible for the wave of
bank failures in the early 1930s. White performs a variety of
tests and concludes that securities affiliates d i d not
endanger banks.
A d d i t i o n a l allegations arising from this period concern
trust departments' relationships with investment affiliates and investment companies' (now called mutual
funds) relationship with their commercial bank sponsors.
^Congressional Record (1932), 1931-32.
See, for example, "Big Bankers' Gambling Mania,'' The
Literary Digest, March I I , 1933, 11-12.
''Indeed, the issue of misplaced confidence would probably not exist at this time if the Glass-Steagall Act had
4
never been passed. The stock market crash of 1929 taught
investors that even securities promoted by bank affiliates
could suffer significant losses.
6
H e also points out that one important study suggesting
that securities activities are riskier than t r a d i t i o n a l
banking, Boyd and Graham (1988), misclassifies six of the
firms labeled as securities firms.
7
Benston inaccurately states (in chapter 9) that "concerns
for concentration of power by commercial banks over corporations d i d not arise before the passage of the GlassSteagall Act." In fact, such concerns had existed at least
since the House of Representatives conducted the Pujo
Hearings, which investigated the concentration of the control of money and credit (Pujo Report 1913).
References
Boyd, lohn H„ and Stanley L. Graham. "The Profitability and
Risk Effects of Allowing Bank Holding Companies to
Merge with Other Financial Firms: A Simulation Study."
Federal Reserve Bank of Minneapolis Quarterly Review
(Spring 1988): 3-20.
Branch, Chain, and Group Banking Hearings. U.S. Congress.
House. Branch, Chain, and Group Banking. Hearings
before the House Committee on Banking and Currency.
71st Cong., 2d sess., 1930. Vol. 2, pt. 15.
Carosso, Vincent. Investment Banking in America: A History.
Cambridge, Mass.: Harvard University Press, 1970.
Congressional Record. 72d Cong., I st sess., 2 May 1932 to 17
May 1932. Vol. 75., pt. 9., 9357-10494. Washington, D.C.,
1932.
,73d Cong., I st sess., 12 May 1933 to 25 May 1933.
Vol. 77, pt. 4, 3295-4326. Washington, D.C., 1933.
Edwards, George W. "The Myth of the Security Affiliate."
Journal of the American Statistical Association 37 (1942):
225-32.
Foreign Bond Hearings. U.S. Congress. Senate. Sale of
Foreign Bonds or Securities in the United States. Hearings before the Senate Committee on Finance. 72d Cong.,
1st sess., 1931 and 1932.
Glass Subcommittee Hearings. Operation of the National
and Federal Reserve Banking Systems. Hearings before a
Subcommittee of the Senate Committee on Banking and
Currency. 71st Cong., 3d sess. 1931. pts. 1-6, VII.
. Operation of the National and Federal Reserve
Banking Systems. Hearings on S. 4115 before the Senate
Comm ittee on Banki ng and Currency. 72d Cong., 1 st sess.,
1932.
Glass Subcommittee Report. Operation of the National and
Federal Reserve Banking Systems. Report No. 584 to
accompany S. 4412, 22 April 1932.
Guenther, Robert. "Securities Group May Agree to Bigger
Role for Banks." Wall Street journal November 29, 1989,
CI, C19.
48
Isaac, William M., and Melanie L. Fein. "Facing the Future:
Life Without Glass-Steagall." Catholic University Law
Review 37 (Winter 1988): 281-346.
Macey, lonathan R. "Special Interest Groups Legislation and
the Judicial Function: The Dilemma of Glass-Steagall."
Emory Law journal 33 (Winter 1984): 1-40.
Moore, Terris. "Security Affiliate versus Private Investment
Banker: A Study in Security Originations." Harvard Business Review 12 duly 1934): 480-82.
Pecora, Ferdinand. Wall Street Under Oath: The Story of Our
Modern Moneychangers. New York: Simon and Schuster,
1939.
Pecora Hearings. U.S. Congress. Senate. Stock Exchange
Practices. Hearings on S. Res. 56, S. Res. 84, and S. Res. 97
before the Senate Committee on Banking and Currency.
73d Cong., 2d sess., 1933 and 1934.
Pujo Report. U.S. Congress, House. Report of
appointed pursuant to House Resolutions
investigate the concentration of control
credit. House C o m m i t t e e on Banking
1913.
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Part 2: The Statistical Survey of Investment Trusts and
Investment Companies. 76th Cong., I st sess., 3 lanuary
1939. H. Doc. 70, 1939a.
. U.S. Securities and Exchange Commission.
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Companies:
Commingled or Common Trust Funds Administered
by
Banksand TYustCompanies. 76th Cong., 2d sess., 23 September 1939. H. Doc. 476, 1939b.
. U.S. Securities and Exchange Commission.
Study of Investment Trusts and Investment
Companies:
Part 3, Chapters I and II, Abuses and Deficiencies in the
Organization and Operation of Investment Trusts and
Investment Companies. 76th Cong., I st sess., 3 May 1939.
H. Doc. 279, 1940.
E C O N O M I C R E V I E W , M A R C H / A P R I L 1990
U.S. Securities and Exchange Commission.
Study of Investment Trusts and Investment
Companies:
Part 3, Chapter VII, Abuses and Deficiencies
in the
Organization and Operation of Investment Trusts and
Investment Companies. 77th Cong., 1 st sess., 26 February
1941. H. Doc. 136, 1942.
SEP Report. Stock Exchange Practices, Report of the Committee On Banking and Currency, pursuant to S. Res. 84
(72d Congress) and S. Res. 56 and S. Res. 97 (73d Con-
gress). Washington, D C.: U.S. Government Printing Office, 1934.
Silver, David. Written Statement of the Investment Company
Institute Before the Senate Committee
on Banking,
Housing and Urban Affairs, 23 ]anuary 1987.
White, Eugene N, "Before the Glass-Steagali Act: An Analysis of the Investment Banking Activities of National
Banks." Explorations in Economic History 23. (1986):
33-55.
I7
FEDERAL RESERVE B A N K O F ATLANTA
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