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Dollarization:
A Scorecard
R O B E R T O
C H A N G
The author is an associate professor at Rutgers
University. At the time this article was written, he was
a research officer in the macropolicy section of the
Atlanta Fed’s research department. He thanks Marco
Espinosa, Frank King, Will Roberds, George Selgin,
and Ellis Tallman for useful comments and suggestions and Michael Chriszt for valuable assistance.
I
N
J ANUARY
OF THIS YEAR ,
J AMIL M AHUAD ,
THEN PRESIDENT OF
E CUADOR ,
STARTLED HIS
COMPATRIOTS BY PROPOSING TO ELIMINATE THE NATIONAL CURRENCY, THE SUCRE . I NSTEAD ,
M AHUAD
S UCH
ADVANCED , THE
U.S.
DOLLAR WOULD REPLACE THE SUCRE FOR ALL PURPOSES .
A CHANGE WOULD STABILIZE
E CUADOR ’ S
and help return the country to growth and prosperity.
Mahuad’s announcement was received with skepticism, and a popular uprising forced him out of office
a week later. But the succeeding government has
actually implemented Mahuad’s proposal and
recently announced that U.S. dollars will have completely replaced the sucre by September 2000.
The question remains as to whether the
Ecuadorian plan will be successful and, more generally, whether other countries will follow Ecuador’s
lead. But one thing is clear: proposals to replace the
domestic currency with the U.S. dollar, or to “dollarize” the economy, have taken center stage in
Latin America and other developing regions. The
idea is the subject of hot debates in academic and
policy circles. And where candidates stand with
respect to dollarization has become a key factor in
several political contests.
The ascent of dollarization from being a relatively neglected issue to the role of powerful economic medicine is mysterious and fascinating. It
implies, for example, that as monetary policy in
advanced economies has steadily gained respect,
developing nations have come to believe it is better
to get rid of their own currencies. To illustrate why,
SINKING ECONOMY AFTER A DISMAL
1999
this article will discuss the currently fashionable
proposals for dollarization in Latin America and
other developing regions.
After describing what dollarization is about, the
article places special emphasis on identifying and
analyzing various arguments for and against dollarization in the light of existing economic theory
and evidence. By embracing dollarization, a developing country would accept at least three costly
consequences:
• Its government would give up the revenue it
enjoys from creating money.
• Its central bank would no longer serve as a
lender of last resort to domestic banks.
• It would no longer control domestic monetary
policy.
On the other side of the ledger, dollarization may
result in at least two benefits:
• Dollarization may lower the country’s cost of
foreign credit.
• It may enhance the credibility of government
policy.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
1
Are the benefits from dollarization worth its
costs? The answer is unclear. Comparing the relative significance of the costs and benefits listed
involves many difficulties. The article discusses
these issues and, as it moves down the list, it finds
that measurement problems become considerably
larger. The conclusion is that, remarkably, the popular belief that dollarization is a desirable reform has
been reached in spite of widespread uncertainty
about its economic benefits.
tries? In contrast to many other economic reforms,
recent dollarization proposals are very simple.
Essentially, two exchanges would have to be enacted:
• The domestic monetary base, that is, all local
currency (coins and notes) in circulation plus
the vault cash reserves of banks, would be
redeemed for U.S. dollar bills at some predetermined conversion rate and then destroyed. In
Ecuador, for example, the central bank is currently paying one dollar for each twenty-fivethousand-sucre coin and note presented to it.
• All contracts denominated in local currency would
be transformed into contracts in U.S. dollars, also
at predetermined conversion rates (which may,
but do not necessarily, equal the rate for coins and
bills). In particular, local currency bank deposits
would become deposits denominated in and
payable in dollars.
Official Dollarization: What It Is and What It Is Not
ost nations have their own currencies, but
in a number of countries the U.S. dollar is
also used widely as a means of payment,
store of value, and unit of account. This phenomenon, which may be
called unofficial dollarization, became
As inflation rates in
manifest in the 1980s
in some economies
Mexico, Israel, Peru, and
experiencing rapid
other countries reached
inflation. As inflation
triple digits, domestic resirates in Mexico,
Israel, Peru, and other
dents learned to protect
countries reached
themselves against the loss
triple digits, domestic
of purchasing power of
residents learned to
protect themselves
their national currencies
against the loss of
by switching to the dollar.
purchasing power of
their national currencies by switching to
the dollar. Over time, the governments of these
countries validated unofficial dollarization by allowing residents to open bank accounts denominated in
dollars and by including dollars in circulation and
dollar deposits in their own monetary statistics.
In spite of the growing importance of dollarization,
attention to it remained confined to a relatively small
and mostly academic literature.1 This state of affairs
changed, however, with the sequence of crises in
emerging markets that started with the Mexican one
in 1994–95 and continued with the 1997–98 crises in
Asia, Russia, and Brazil. The observation that dramatic and costly devaluations of national currencies
were common to most crises led to a renewed search
for alternative exchange rate arrangements. Official
dollarization emerged then as a feasible and intriguing possibility. But its popularity ballooned after
President Carlos Menem of Argentina announced at
the beginning of 1999 that he was seriously considering a dollarization plan.
What would official dollarization actually involve
for Argentina, Ecuador, and similar developing coun-
M
2
Three features of this scheme deserve particular
emphasis. First, dollarization would be unilateral.
Ecuador did not ask the U.S. government for permission to implement its dollarization scheme, nor
did it have to. Second, and as a consequence, under
this plan a government would give up any power to
conduct independent monetary policy and would
implicitly accept the monetary policy decisions of
the U.S. Federal Reserve. Ecuador’s decision to dollarize gave it neither a voice nor a vote in the
Federal Open Market Committee. Third, the local
currency would be completely replaced by the dollar,
not just by a dollar equivalent.
These aspects are noteworthy because they set
dollarization apart from some alternatives.2 For
instance, instead of pursuing dollarization unilaterally, a developing country could try to negotiate a
Treaty of Monetary Association with the United
States. Such a treaty would entitle the dollarizing
country to some transfers from the U.S. government
(and, ultimately, from the U.S. taxpayer) as compensation for the loss of monetary policy independence. A more encompassing alternative would be
to negotiate a monetary union similar to the current
European Monetary System. In a monetary union,
the United States and the developing country would
agree to have a common currency, which could be
the U.S. dollar, and a common monetary authority.
Hence the developing country would presumably
gain some control over monetary policy decisions.
It has become evident that neither a monetary association treaty nor a monetary union would be feasible
without prolonged and complex negotiations between
the U.S. government and the developing countries
involved. As a consequence, some developing nations,
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
led by Argentina, have moved almost all the way
toward dollarization and established a currency
board system. In a “pure” currency board, the central
bank stands ready to buy or sell U.S. dollars for
domestic currency at a fixed exchange rate; in addition, the currency board does not issue domestic currency in exchange for local currency assets. This
commitment is, in turn, guaranteed to be permanent
because the amount of domestic currency in circulation is fully backed by U.S. dollars held by the central
bank. This arrangement does not eliminate the local
currency but makes it, in principle, completely equivalent to the U.S. dollar. That would indeed be the
outcome in Argentina if holders of Argentinean pesos
were 100 percent sure that the central bank of
Argentina would always be there to pay one dollar for
each peso in circulation.3
If in fact a government can make the national currency a perfect substitute for the U.S. dollar by
establishing a currency board, what are the further
gains from official dollarization? On the other hand,
if dollarizing the economy is so straightforward, why
not just do it? The answer to both questions, of
course, is that dollarization may have costs as well
as benefits, to which the discussion now turns.
The Seigniorage Question
country engaging in official dollarization
would naturally have to destroy its national
currency. This fact has been used by some to
argue against dollarization on the basis of national
pride, symbols, traditions, and the like. While such
arguments can be politically effective, their economic significance is virtually impossible to evaluate.
Perhaps as a consequence, economists have avoided
debating these political factors. Instead, economic
theory identifies other reasons why it is costly for a
nation to eliminate its national currency. Some of
the losses can be readily quantified, and they turn
out to be significant in practice.
The first source of losses from dollarization is
what is called seigniorage. The right to create
domestic currency is valuable for a government
because newly printed currency can be issued in
exchange for goods and services. For example,
newly printed pesos, which cost essentially nothing
to produce, allow the Bank of Mexico to pay for purchases of goods or for foreign exchange as well as
A
to grant credits to domestic banks. This is what
economists mean when they say that a government
collects revenue when it prints domestic currency
or, in other words, that it extracts seigniorage revenues from the economy.
A dollarizing country would give up its seigniorage revenues, which would accrue instead to the
U.S. government. For developing countries, the loss
can be large. To illustrate, the significance of annual
seigniorage revenues has been calculated for
Argentina, Brazil, and Mexico, over the 1993–97
period for Argentina and Mexico and 1995–97 for
Brazil (the difference being that for Brazil previous
years are abnormally turbulent.)4
Chart 1 displays the actual flow of revenue from
printing domestic currency, given by the increase in
the domestic monetary base in a year, both in terms
of U.S. dollars and as a percentage of the country’s
gross national product (GDP). Accordingly, the
chart shows that seigniorage revenue per year has
been about one-third of 1 percent of GDP for
Argentina, or U.S.$1.2 billion per year. In contrast,
seigniorage revenues in Brazil have been about
1.3 percent of GDP, or U.S.$10 billion per year. In
other words, after correcting for the relative size of
the Argentinean and the Brazilian economies, the
seigniorage transfer from Brazil to the United States
under dollarization would be more than three times
larger than the corresponding transfer from
Argentina to the United States. These figures
explain, perhaps, why the dollarization idea has
been clearly more popular in Argentina than in Brazil.
Mexico turns out to be a middle case: annual seigniorage revenues amount to nine-tenths of 1 percent of
GDP, about U.S.$3.8 billion.
The different magnitudes of seigniorage in
Argentina, Brazil, and Mexico reflect the different
degrees to which their governments have relied on
money creation to finance their budgets. Chart 2
shows that money creation is only 1.7 percent of
total government revenue in Argentina. Therefore
losing seigniorage would not require a major fiscal
adjustment in that country. But in Brazil, domestic
money creation is responsible for almost 9 percent
of government revenue. As a consequence, dollarization would require Brazil to find new and significant sources of tax revenues or to drastically reduce
government expenditures. While the fiscal effects
1. For a taste of the literature prior to the 1994 Mexico crisis, see Chang (1994) and the references therein.
2. See Berg and Borensztein (2000) for a more detailed discussion.
3. Argentina’s system, called the Convertibility Law, departs from a pure currency board in a number of ways. For example, up
to one-third of the central bank’s reserves that back base money can be held in the form of Argentinean government bonds.
For a full discussion, see Hanke and Schuler (1999), who also argue for a move toward official dollarization.
4. The method for calculating seigniorage revenues follows Fischer (1982).
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
3
C H A R T 1 Flow of Revenue from Seigniorage as a Percentage of GDP
1.4
U.S.$10.0 billion
Percent
1.0
U.S.$3.8 billion
0.6
U.S.$1.2 billion
0.2
Argentina
1993–97 average
Brazil
1995–97 average
Mexico
1993–97 average
Source: International Financial Statistics
C H A R T 2 Flow of Revenue from Seigniorage as a Percentage of Total Government Revenue
10
U.S.$10.0 billion
Percent
8
6
U.S.$3.8 billion
4
U.S.$1.2 billion
2
0
Argentina
1993–97 average
Brazil
1995–97 average
Mexico
1993–97 average
Source: International Financial Statistics
would not be as large for Mexico, seigniorage is
about 4.7 percent of total government revenue.
The numbers just quoted refer to what is called
flow seigniorage, the amount of resources that
Argentina, Brazil, and Mexico would have to transfer to the United States each year in order to obtain
dollar bills. In addition to these annual transfers,
dollarization would require exchanging the existing
amounts of domestic currency in circulation for U.S.
dollars, entailing an additional, one-time startup
cost equal to the dollar value of the domestic currency in circulation.
4
Chart 3 shows the magnitude of this startup cost.
For the three countries under analysis, the cost is
substantial, between 2 percent and 4 percent of
GDP. The relatively smaller cost for Brazil reflects a
smaller demand for domestic currency, which is natural because hyperinflation was perceived as a
major threat until very recently. Note that the cost,
when expressed in absolute dollar amounts, is very
similar in the three cases (U.S.$14 billion–15 billion).
The conclusion is that dollarization would imply a
fairly large seigniorage transfer from a dollarizing
country to the United States. For Argentina, the
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
C H A R T 3 Cost of Replacing Domestic Currency in Circulation with U.S. Dollars
U.S.$13.6 billion
4
Percent of GDP
U.S.$13.9 billion
3
U.S.$15.8 billion
2
1
0
Argentina
1993–97 average
Brazil
1995–97 average
Mexico
1993–97 average
Source: International Financial Statistics
transfer would be paid mostly up front while for
Brazil the transfer would be paid mostly over time.
Mexico seems to be an intermediate case. The
amounts involved are clearly identifiable and relatively straightforward to calculate.5
Even the most ardent proponents of dollarization do admit that the loss of seigniorage is an
important drawback. To mitigate the effects, it has
been suggested that a dollarizing nation should
engage in negotiations with the United States to
recover some of the seigniorage revenue involved.
But it is fair to say that there is little reason to be
optimistic about prospects for such negotiations in
the short run.
There is an important caveat. The discussion has
assumed, implicitly, that the loss of seigniorage revenue is costly. That assumption is usually accepted
even by dollarization proponents, but is a debatable
one. In particular, it has been argued that the loss of
seigniorage may be beneficial if it forces an otherwise irresponsible government to choose sound
policies. This key contention is taken up later in this
article. For the time being, it suffices to note that
the loss of seigniorage would be costly even if the
government were completely responsible. In such
a case, however, the calculation of the seigniorage
lost with dollarization may have to be based on the
inflation rate that would be chosen by such a government, which may be lower than past inflation (see
Chang and Velasco 2000a).
The Lender of Last Resort
second issue with official dollarization is that
a country’s central bank would no longer
serve as the lender of last resort to the
domestic banking system. A lender of last resort is
an institution that stands ready to provide credit to
banks in the event that they experience a sudden
demand for liquidity, as when bank runs occur. Such
an institution is crucial in a system of banks with
fractional reserves in order to reassure bank depositors and short-term creditors that their claims on
the banks will be honored if they attempt to liquidate them. If there is no lender of last resort, confidence crises and bank runs become more likely and
more damaging if they occur.6
In most countries, the role of lender of last resort
has traditionally been played by the central bank.
This role is natural because the central bank can
create credit quickly and at a negligible cost simply
by issuing domestic currency. Since the ability to
print currency would disappear under official dollarization, the central bank would no longer be able
to serve as the lender of last resort.
A
5. Incidentally, the amounts in Chart 3 may be taken as not only the startup costs of dollarization but also the potential profit of
reintroducing a national currency from the viewpoint of a government in a dollarized economy. In other words, these amounts
are a measure of the temptation to renege on the implicit promise that dollarization is a permanent reform.
6. U.S. history, in fact, provides a good example of the importance of the lender of last resort. Miron (1986) and others have
documented that bank panics became less frequent after the establishment of the Federal Reserve.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
5
The associated cost is hard to quantify, however.
For one thing, the cost depends on what system dollarization is replacing. In Argentina, for instance,
dollarization would replace a currency board system. But, as shown formally by Chang and Velasco
(2000c), a central bank cannot effectively act as a
lender of last resort if it is fixing the exchange rate,
as in a currency board system. In other words, moving from a currency board to dollarization would not
change the ability of the central bank to act as a
lender of last resort: that ability does not exist in the
first place. On the other hand, in countries with flexible exchange rates, such as Brazil and Mexico, the
central bank can act as a lender of last resort.
Dollarization may
therefore be more
costly in these cases
because of the need
to implement an alterUnder dollarization a govnative arrangement.
ernment would give up any
In addition, dollarpower to conduct indepenization (or, for that
matter, a currency
dent monetary policy and
board or a fixed exwould implicitly accept the
change rate system)
monetary policy decisions
would not imply the
complete absence of a
of the U.S. Federal Reserve.
lender of last resort,
only that the central
bank cannot perform
that role. There are a
number of alternatives open to a dollarized country.
The government could set aside a liquid fund to be
lent to banks in a crisis. Another possibility would be
for the government to secure lines of credit from
abroad that could be drawn upon in the event, and
only in the event, of a banking crisis. Argentina, in
fact, has been implementing the latter strategy since
the Tequila Crisis of 1995. However, both alternatives
are more costly than having the central bank serve as
the lender of last resort. And there is considerable
debate about how to calculate that cost in practice.
Argentina provides an excellent illustration of these
points. In 1995, following the Mexican crisis of
December 1994, the Argentinean banking system
came under intense pressure; in particular, there was
a massive liquidation of domestic deposits, caused by
growing expectations of bank failures. Because
Argentina was committed to a currency board system,
the central bank could not assist domestic banks with
emergency credit. In other words, the rules of the currency board did not then (and do not now) allow the
central bank to act freely as a lender of last resort.
In 1995 the situation was saved thanks to a rescue
package orchestrated by the International Monetary
6
Fund and the World Bank. After that scare, the
Argentinean government secured lines of credit from
foreign private banks to be used in case of an emergency. This arrangement clearly helps replace the
lender of last resort, but it is not free. Argentina must
pay a premium for what is essentially an option to borrow. In addition, it is not clear whether the credit lines
are large enough to replace what the central bank
might be able to do as a lender of last resort. In particular, in a crisis, banks may need enough liquidity
assistance to meet all of their demandable obligations,
as stressed by Chang and Velasco (2000c). To be
effective, the Argentinean lines of credit may therefore need to be much larger than they actually are.
It may be instructive to attempt at least a very
rough calculation of the cost of the Argentinean
strategy. In 1996 the Argentinean private line of
credit reached U.S.$6.1 billion, at a cost of about
U.S.$18 million a year—about 0.3 percent.
Assuming that this rate remains the same, the total
cost of the strategy would depend on how large a
credit line is “enough.” At the end of 1999,
Argentina’s M2 (the sum of its banking system monetary and quasimonetary liabilities) was U.S.$88.2
billion. Since it had U.S.$26.5 billion in international
reserves, the banking system’s net liquid liabilities
were arguably as large as U.S.$88.2 billion – U.S.$26.5
billion = U.S.$51.7 billion. At 0.3 percent a year, a
line of credit large enough to cover that amount in
whole would cost somewhat more than U.S.$150
million per year. While this is not a negligible figure,
it is only a small fraction of Argentina’s GDP.
Of course, the calculation just performed could be
refined in several ways. However, the point is
twofold. First, replacing the domestic central bank
with an Argentina-style line-of-credit approach
would be a negative consequence of dollarization.
Second, the cost can be calculated explicitly. For
Argentina, the cost turns out to be relatively minor,
and it is much smaller than that associated with the
loss of seigniorage.
To end the discussion of the Argentinean strategy,
it should be noted that significant enforcement
questions remain unsettled. Will the foreign banks
involved be reliable enough to deliver on their contractual obligations in a time of crisis instead of
defaulting? Who would enforce the contracts
between Argentina and the creditor banks? And
who would ensure that the creditors themselves
have access to the necessary liquidity?
Losing Independent Monetary Policy
t is widely accepted that, in modern economies,
conditions in the domestic market for money are
crucial determinants of macroeconomic outcomes.
I
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
There is debate about what concept of “money” is
relevant for analysis. However, whatever that concept is, it must include at least the monetary base,
that is, local currency in circulation and in bank
vaults. By controlling the monetary base, a central
bank affects the domestic market for money and,
consequently, may have an impact on real (inflationadjusted) activity and inflation. With official dollarization, the domestic central bank would no longer
have access to its key policy tool, the monetary
base. In this sense, there would simply be no sovereign monetary policy.
Whether the loss of monetary autonomy is costly
in practice is controversial. This fact may come as a
surprise, particularly to readers who believe in the
effectiveness of monetary policy. Nevertheless, as
the discussion will show, it has been argued that the
loss of independent monetary policy would entail
essentially no cost to developing economies.
There are many sides to this contention. One
depends, as with the question of the lender of last
resort, on what system dollarization is compared
with. If dollarization is considered as the alternative
to a currency board, as in Argentina, then the loss of
monetary independence is not an issue: in a currency
board, there is no such independence anyway. The
issue of independence emerges only if dollarization is
considered against exchange rate flexibility.
Even then, there are those who argue that the
issue is moot. For instance, Hausmann and others
(1999) have observed that, in response to the
1997–98 emerging markets crises, interest rates
were least variable in countries with more rigid
exchange rate systems. At the same time, exchange
rates moved very little in countries with flexible
exchange rate systems. Hausmann and others
attribute this combination to the fact that, in this
period, countries with flexible exchange rates raised
interest rates aggressively to defend their currencies. Hence they state that “Latin American Central
Banks used their exchange rate flexibility very sparingly, even when they formally float or have wide
bands” (1999, 7). The implication is that whatever
policy leverage is lost with dollarization is unimportant as it would not be used even if exchange rates
were flexible.
However, the fact that central banks try to smooth
exchange rate fluctuations is not an argument in
favor of fixing exchange rates, currency boards, or
dollarization. Such a behavior is neither inconsistent
with floating exchange rates nor suboptimal in principle. Further, it can be shown that even if exchange
rate stabilization were not a primary goal for the
central bank, monetary instruments—and consequently interest rates—would still have to react to
exchange rates. This reaction would occur because,
as discussed by Chang and Velasco (2000b), current
exchange rate movements carry information that is
useful for predicting future goal variables, such as
future inflation or employment.
Perhaps most importantly, a recent study by Ghosh
and others (1997) provides convincing evidence that
more rigid exchange rate systems result in larger
fluctuations in output and employment and in perhaps less growth. Table 1 summarizes the implications for developing countries. The table compares
developing countries under pegged, floating, and
intermediate exchange rate systems in terms of their
economic performance. The latter is measured by the
level and volatility of inflation, growth, and employment relative to the average for all countries. Hence,
the leftmost number of the first row, 0.00, indicates
that developing countries with pegged exchange
rates grew, on average, at the same rate as a typical
country. In contrast, the third number of the first row,
0.50, indicates that developing countries with floating
exchange rates grew, on average, half a percentage
point faster per year than the typical country.
From the table, it is apparent that floating
exchange rate regimes have enjoyed faster growth
T A B L E 1 Developing Countries: Exchange Rate Regimes and Macroeconomic Performance
Average for Various Exchange Rate Regimesa
Pegged
Intermediate
Floating
Output Growth
Level
Volatility
0.00
0.08
0.70
–0.80
0.50
–0.52
Employment Volatility
0.05
0.01
–0.32
–2.90
–1.74
–0.10
0.53
3.80
1.67
Inflation Rate
Level
Volatility
a
For the countries with each type of exchange rate regime, the figures are the average, in percent, of the deviation from the average of all
countries.
Source: Goldfajn and Olivares (2000), based on Ghosh and others (1997)
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
7
and less volatility in output and employment than
fixed rate regimes. The cost of this accomplishment
has been substantially higher and more variable inflation. These results are consistent with the view that
flexible exchange rates allow a government to cushion the impact of exogenous shocks on output and
employment, even at the cost of generating inflation.
But the fact that flexible exchange rates allow for the
existence of a trade-off seems indisputable.7
The remaining question is whether that is a tradeoff worth having. The net cost associated with the
loss of monetary independence depends, at the end,
on the value of a more stable price level that dollarization brings about relative to the more satisfactory
behavior of output and employment associated with
flexible exchange rates. The answer is unclear and
likely to depend on the specific characteristics of
individual countries.
Would Dollarization Lower the Cost of Credit?
p to this point, the discussion has mentioned
a number of costly consequences of official
dollarization. But dollarization has some
favorable aspects, as one should expect. One of
them is that the risk of currency devaluation would
not exist because the domestic currency would disappear. As a consequence, dollarization proponents
argue, the cost of foreign credit for a dollarizing
country would come down, stimulating investment
and economic growth.8
However, that dollarization would result in a lower
cost of credit is not as straightforward as it might
sound. Consider what determines the interest rate
that a resident of a developing economy must pay to
borrow in the world market. If the loan is denominated in U.S. dollars, there is often a difference or
spread between the rate charged to that borrower
and the rate lenders would charge to otherwise similar American borrowers. That difference is what is
called default risk or sovereign risk. It reflects the
possibility of a developing country’s default on its
foreign debt. Such a possibility increases the cost of
credit for all domestic agents. Even if default can be
declared only by the government on official debt,
domestic residents are likely to also stop or have difficulties servicing their individual obligations.9
If the loan is denominated not in dollars but in
domestic currency, there may be an additional
spread component that compensates lenders for the
possibility of a devaluation of the domestic currency.
In other words, the spread must also incorporate
devaluation risk.
Since dollarization would imply the elimination of
the national currency, there would no longer be
domestic currency loans, and in this sense devaluation
U
8
risk would disappear. However, it does not necessarily follow that the cost of credit would be lower for
domestic residents. Instead, those that had the
option of borrowing domestic currency before dollarization would be forced to take dollar loans
instead. Thus, other things being equal, dollarization
would be detrimental to those borrowers because,
before dollarization, they presumably could have
borrowed in dollars but chose not to.
The hope of dollarization advocates, however, is
that the disappearance of devaluation risk would also
reduce sovereign risk and hence result in lower dollar interest rates. This development may occur for at
least two reasons. First, domestic residents or the
government often have foreign currency liabilities
but revenues that depend on the value of the domestic currency. A devaluation of the currency then
increases the relative value of the liabilities, causing
domestic bankruptcies. This situation, implied by the
currency mismatch of assets and liabilities, would
presumably be avoided with dollarization. Second, a
government that is committed to defending the
value of the national currency may resort to capital
controls in order to fend off speculative attacks.
Capital controls may, in turn, force domestic borrowers into default on their foreign debts.
However, it is also possible that eliminating devaluation risk may increase sovereign risk instead
of reducing it. In particular, Chang and Velasco
(2000c) showed that, in a theoretical model, a currency board or official dollarization may “succeed”
in eliminating devaluations. However, such a success comes at the cost of preventing the central
bank from acting as lender of last resort to domestic
banks and implies the possibility of bank runs. In
contrast, a flexible exchange rate system allows the
central bank to create domestic credit to help banks
in case of trouble and eliminates costly speculative
runs. The implication, if domestic banks have foreign debts, is that flexible exchange rates may help
reduce the risk of default on those debts. A different
mechanism, emphasized by Berg and Borensztein
(2000), is that a devaluation may have expansionary
economic effects, which may improve fiscal revenues and reduce pressures for default.
Unfortunately, the empirical evidence is not very
helpful in clarifying whether dollarization would
reduce sovereign risk. To illustrate why, Chart 4 displays measures of sovereign risk for Argentina,
Brazil, Mexico, and Peru during the second half of
1998 and all of 1999. Sovereign risk is measured by
the difference between the yield of each country’s
Brady bonds and the yield on five-year U.S.
Treasury bonds. The chart shows no discernible
relation between sovereign risk and whether
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
C H A R T 4 Sovereign Risk
3000
1000
0
July
1998
Argentina
–––––
–––––
2000
–––––
Basis points
– – – – – Brazil
Peru
January
1999
Mexico
July
Note: Each country’s graph is its Brady bond discount stripped yield minus the five-year U.S. Treasury yield, in basis points.
Source: Calculated by the Federal Reserve Bank of Atlanta using data from BancBoston Robertson Stephens, Inc., and the Board of
Governors of the Federal Reserve System.
exchange rates are fixed or flexible. Argentina maintained a currency board and for most of the period
had to pay a sovereign spread higher than that of
Mexico or Peru, both of which maintained flexible
exchange rates. On the other hand, the Argentinean
spread was lower than Brazil’s, even after Brazil
switched to a flexible rate regime at the beginning of
1999. Also, the chart shows that the sovereign
spreads of the four countries moved together after
the Russian crisis of August 1998 and the Brazilian
devaluation of January 1999. The chart thus underscores the fact that, to a large extent, sovereign
spread movements reflect shocks that affect developing countries as a whole, independently of their
exchange rate regimes.
The above remarks apply even for the case of
Panama, which has been officially dollarized since
1904. Berg and Borensztein (2000), in particular,
point out that Panama’s sovereign spread has been
very similar to Argentina’s and was strongly affected
by the Asian, Russian, and Brazilian crises. And
Goldfajn and Olivares (2000) document that in 1998
and 1999 Panama’s sovereign spread was considerably higher than that paid by Costa Rica, which
maintained a flexible exchange rate system.
One can dispute the evidence just presented on a
number of counts. The most important one may be
that the international comparison of sovereign
spreads should take into account not only their
exchange rate regimes but also the influence of
other, country-specific characteristics. But the fact
remains that evidence that dollarization is likely to
reduce sovereign risk premia and dollar interest
rates is still missing.
Dollarization and Policy Credibility
inally, one often hears that official dollarization would be beneficial because it would
enhance the credibility of domestic policy.
This contention is very difficult to evaluate, partly
because the word “credibility” has been employed in
many different senses and partly because there has
been virtually no success at quantifying the size of
the potential credibility gains.
F
7. One may argue that the data in Table 1 are consistent with a different view: that economic characteristics determine exchange
rate regimes and not vice versa. This case would hold if, in particular, low-inflation countries are better able to maintain
pegged exchange rates. However, Ghosh and others (1997) investigate this “reverse causation” possibility and conclude that
it makes little difference to their results.
8. For instance, Hanke and Schuler observe, “The major benefit of dollarization [in Argentina] would be reduced interest rates”
(1999, 407).
9. This would be the case if, in particular, a government’s default is coupled with exchange restrictions and capital controls, limiting
the private sector’s access to hard currency.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
9
One sense in which policy would be more credible is that official dollarization would be more difficult to reverse than other fixed exchange rate
schemes. This contention has been most prominent in Argentina. There, the prevailing currency
board system is widely regarded as having played
a key role in lowering inflation in the 1990s. In
spite of that success and repeated official
announcements to the contrary, there remains a
market expectation that the currency board may
be abandoned. This market perception is evident
from comparing dollar interest rates against
Argentinean peso
interest rates on otherwise similar financial
securities. The spread
between peso- and
The costs of dollarization
dollar-denominated
eurobonds, for inare by and large identifiable
stance, averaged 2.5
and can be quantified. On
percentage points
the other hand, the benefits
during the 1997–98
period, indicating
from dollarization remain to
that international
be demonstrated.
investors demanded
compensation for the
risk of the government’s possibly abandoning the currency
board and a subsequent devaluation of the peso.
While the Argentinean government could end its
currency board system virtually overnight if it
wished to, it may be much more difficult to reverse
official dollarization. Such a reversal would entail
reintroducing national currency and, presumably,
convincing domestic residents to turn in their holdings of dollars. Seen in that light, official dollarization
would be a more “credible” arrangement than maintaining a currency board with an uncertain future.
But a further question emerges: are there clear
benefits from such marginal gains in credibility?
Dollarization enthusiasts hope for a positive answer
in at least three respects. The first is that, by eliminating the possibility of devaluation, enhanced credibility will help reduce interest rates. It has already
been argued, however, that it is unclear whether
such a promise will materialize.
The second benefit from the irreversibility of dollarization is, in fact, that monetary policy will be
taken out of the hands of the domestic central bank.
Calling this development a benefit may sound paradoxical, but if the central bank cannot fully commit
to its policy announcements then there is a benefit
in taking control away. Specifically, it may be the
case that the central bank has incentives to promise
10
low inflation ex ante but to engineer unexpectedly
high inflation ex post. By generating surprise inflation, the central bank may stimulate the economy
and increase employment and output. But private
agents will soon understand if there is a systematic
attempt to act in this way and will adjust their
behavior accordingly, possibly not only offsetting
the effectiveness of surprise inflation but also leading to a situation in which average inflation is suboptimally high.
The importance of the argument just stated
remains to be elucidated. While dollarization may
reduce the inflation bias associated with the central
bank’s lack of commitment, it can do so only at the
cost of reduced policy flexibility. Policy flexibility is
advantageous under some circumstances, as when
the economy is hit by exogenous shocks. In addition, taking monetary policy away from domestic
authorities, as dollarization does, is not the only way
to overcome the commitment problem. An alternative is to structure the contracts of central bankers
so as to eliminate their incentives to generate surprise inflation. Finally, it should be observed that in
the last decade average inflation came down in most
developing countries, regardless of their exchange
rate regimes. Annual inflation in Peru was over
7,000 percent in 1990, the same year in which
important economic reforms were enacted, including
flexible exchange rates. Inflation then fell steadily
and has remained in the single digits since the mid1990s. While other cases may not be as dramatic,
the evidence shows that fixing exchange rates has
not been necessary to reduce average inflation.
A third reason that the irreversibility of dollarization may be beneficial is that it may enhance fiscal
discipline. If a government is prone to lax fiscal
behavior, the argument goes, dollarization may impose
some discipline by making it more difficult for the
government to finance excess fiscal behavior. It
might do so by eliminating seigniorage revenues and
inflationary finance and by forcing the government
to issue only foreign currency debt.
The fiscal discipline argument for dollarization
has its own problems. Tornell and Velasco (1995)
have pointed out that its theoretical underpinnings are myopic. Regarding fiscal discipline, they
argue, dollarization differs from flexible exchange
rates not in preventing lax fiscal behavior but in
shifting its costs to the future. A government can
always finance its expenditures today by borrowing. The cost of such a move would be a higher
interest rate if exchange rates were flexible.
Under dollarization, the interest cost may be lower
but the fiscal expenditures have to be paid in some
other way; in most cases, doing so means lowering
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
expenditures or raising taxes tomorrow. Which
alternative acts as a better deterrent for a fiscally
irresponsible government, therefore, depends
largely on the rate at which the government discounts the future. An impatient government
would, in fact, be more disciplined with flexible
exchange rates, which impose immediate costs on
lax fiscal behavior, than in a dollarized regime,
which postpones the time of reckoning.
In addition, the evidence is not supportive of the
idea that more rigid exchange systems enhance fiscal
discipline. As noted by Goldfajn and Olivares (2000),
Panama’s annual fiscal deficit averaged 3.8 percent of
GDP between 1970 and 1998, considerably higher
than the deficits of Chile, Costa Rica, and Peru, where
exchange rates were more flexible. And, in spite of its
currency board, Argentina has had recent difficulties
controlling its fiscal deficit: its fiscal deficit in 1999 is
estimated at 3.8 percent of GDP.
In sum, dollarization advocates are right in arguing that dollarization would be harder to reverse and
in that sense more “credible” than a currency board
or other exchange rate regimes. But whether that
irreversibility would translate into actual benefits to
the economy is more uncertain. Further, there has
been virtually no attempt to quantify the net benefits associated with the credibility argument.
Conclusion
here is an old movie in which the leader of
the world’s smallest country asks his advisers
how to handle an economic crisis. One minister suggests, “Declare a war on the United States.”
When the perplexed leader asks how that would
help, the minister points out that nations like
Germany and Japan fought a war against the United
States, lost, and then became world powers. At first,
the leader seems satisfied with this explanation. But
then he has a doubt and asks, “And what happens if
we win?”
Like declaring war on the United States, official
dollarization would impose considerable costs on a
developing country. And as the discussion has
shown, the costs are by and large identifiable and
can be quantified. On the other hand, the benefits
from dollarization remain to be demonstrated. As in
the war story, it is not even clear what would happen if dollarization won.
T
REFERENCES
BERG, ANDREW, AND EDUARDO BORENSZTEIN. 2000. “The
Pros and Cons of Full Dollarization.” International
Monetary Fund Working Paper WP/00/50, March.
GOLDFAJN, ILAN, AND GINO OLIVARES. 2000. “Is Adopting
Full Dollarization the Solution? A Look at the Evidence.”
Pontifícia Universidade Católica do Rio de Janeiro.
Unpublished paper.
CHANG, ROBERTO. 1994. “Endogenous Currency Substitution, Inflationary Finance, and Welfare.” Journal of
Money, Credit, and Banking 26 (November): 903–16.
HANKE, STEVE H., AND KURT SCHULER. 1999. “A Monetary
Constitution for Argentina: Rules for Dollarization.”
CATO Journal 18 (Winter): 405–20.
CHANG, ROBERTO, AND ANDRÉS VELASCO. 2000a. “Dollarization: Analytical Aspects.” New York University.
Unpublished paper.
HAUSMANN, RICARDO, MICHAEL GAVIN, CARMEN PAGÉS-SERRA,
ERNESTO STEIN. 1999. “Financial Turmoil and the
Choice of Exchange Rate Regime.” Inter-American
Development Bank Working Paper 400.
AND
———. 2000b. “Exchange Rate Policy for Developing
Countries.” American Economic Review 90 (May):
71–75.
MIRON, JEFFREY A. 1986. “Financial Panics, the
Seasonality of the Nominal Interest Rate, and the
Founding of the Fed.” American Economic Review 76
(March): 125–40.
———. 2000c. “Financial Fragility and the Exchange
Rate Regime.” Journal of Economic Theory 92 (May):
1–34.
TORNELL, AARON, AND ANDRÉS VELASCO. 1995. “Fiscal
Discipline and the Choice of Exchange Rate Regime.”
European Economic Review 39 (April): 759–70.
FISCHER, STANLEY. 1982. “Seigniorage and the Case for a
National Money.” Journal of Political Economy 90
(April): 295–313.
GHOSH, ATISH R., ANNE-MARIE GULDE, JONATHAN D. OSTRY,
AND HOLGER C. WOLF. 1997. “Does the Nominal Exchange
Rate Regime Matter?” National Bureau for Economic
Research Working Paper 5874, January.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
11
Credit Crunch or What?
Australian Banks during
the 1986–93 Credit Cycle
E L L I S W. TA L L M A N
N A R G I S B H A R U C H A
A N D
Tallman is a research officer in charge of the macropolicy section of the Atlanta Fed’s research department.
Bharucha is a graduate student at the Woodrow
Wilson School of Public and International Affairs,
Princeton University. The authors thank Graham
Anderson, Marianne Gizycki, Brian Gray, Frank
King, Les Phelps, and Larry Wall for helpful
comments and suggestions. They are especially
grateful for extensive comments from Philip Lowe.1
C
YCLES IN CREDIT HAVE IMPORTANT IMPLICATIONS FOR THE EFFICIENCY OF RESOURCE
ALLOCATION AS WELL AS FOR DEVELOPMENTS IN THE MACROECONOMY.
DURING
THE
UPSWING OF A CYCLE, RAPID CREDIT GROWTH CAN SUPPORT INCREASING ECONOMIC ACTIVITY
AND RISING ASSET PRICES.
CONVERSELY,
boom can exacerbate an economic downturn if financial intermediaries become less willing to lend, thereby
imposing further financial constraints on firms.
When bank loan growth slows or contracts, is this
change due to a reduction of loan supply or loan
demand, or both? Assuming that the typical answer is
“both,” what are the relative contributions of supply
and demand factors for explaining a contraction in
bank loan volume? Finding evidence that credit-supply
constraints reduced loan issuance noticeably in addition to contractions in credit demand would suggest
that the credit-supply constraints could add to the
macroeconomic costs of an economic downturn.
These questions have motivated a plethora of
empirical studies using U.S. banking data to investigate them. The empirical literature has experienced
a major resurgence especially since the observation
of the U.S. credit cycle starting in the mid-1980s.
LOAN LOSSES AND THE UNWINDING OF A CREDIT
Specifically, many researchers have asked whether
there was a “credit crunch” following the institution
of the Basel risk-based capital standards—that is,
whether bank capital supply-induced financial constraints led to observable restrictions on bank loan
growth in the United States. Despite abundant
empirical literature using U.S. banking data, these
basic questions remain unsettled.
Most of the research into supply-based lending
contractions relates to the experience of U.S. banks.
These studies seek to measure a relationship
between indicators of bank financial condition and
bank lending. Hancock, Laing, and Wilcox (1995)
assert that large losses experienced by U.S. banks in
the early 1990s implied a negative shock to bank
capital. They find evidence that such shocks were a
major factor underlying the observed reduction in
bank lending. Bernanke and Lown (1991) also
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
13
demonstrate a link between bank capital and lending by conducting a cross-section study examining
the effect of the ratio of capital to assets on banks’
subsequent loan growth. The study detects a significant relationship, indicating that a fall in the capital
ratio reduces loan growth.2 Hancock, Laing, and
Wilcox (1995) provide evidence not only that lending
declines in response to an economic contraction but
also that banks alter their portfolio composition.3
Kaufman (1992) supports this view, providing evidence that in periods of capital constraint banks
tend to shift away from commercial lending and into
residential mortgages.
Yet Berger and Udell
(1994) offer evidence
Given that developments in
and reasonable alterthe real economy can affect
native hypotheses to
suggest that the evithe financial sector, and
dence supporting the
that developments in the
existence of important
financial sector can affect
supply-based forces
on bank lending is not
the real economy, monetary
significant.
policy must account for
In the pursuit of
changes in the pattern of
more evidence to bear
on the subject, recent
financial intermediation.
empirical work has
examined banking
data from other countries. Kang and Stulz (2000) examine whether banking shocks affected the performance of borrowing
firms in Japan in the early 1990s. The results show
that the firms with a higher proportion of bank loans
performed worse than other firms. In contrast,
Ongena, Smith, and Michalsen (1999) examine the
Norwegian banking crisis (1988–91) and find evidence suggesting that bank distress had only a small
impact on the real economy. More international evidence can be brought to bear on these questions.
This article investigates the credit cycle during
the late 1980s in Australia as additional evidence on
whether supply factors are important to bank loan
behavior. Along with other studies that use banking
data from foreign countries, this article examines
bank loan behavior as if it were an additional creditcycle observation, following the implementation of
the Basel risk-based capital standards.4 There are
key differences and similarities between the U.S.
and Australian banking systems that can be evaluated
up front, and the comparison allows a useful analysis of
the Australian experience as it relates to the general
economic issue of supply-based loan contraction.
Specifically, this article analyzes the 1986–93
credit cycle in Australia, paying particular attention
to the lending behavior of banks during the down14
swing of the cycle. While demand-side factors
account for much of the credit cycle, evidence
is presented consistent with the argument that
supply-side elements also played a role.
The study focuses on the examination of reporting data as collected by the Reserve Bank of
Australia (RBA), in conjunction with information
contained in banks’ annual reports. Analysis of the
data suggests that banks subject to relatively high
levels of impaired assets during the early 1990s
experienced a relatively sharp decline in loan
growth. The results are consistent with the proposition that losses weakened the condition of banks’
balance sheets and added a supply-based element to
the contraction in lending.
Australian banks dramatically altered the composition of their portfolios during this credit cycle. One
interpretation of this observation is that, in
response to strong demand for housing loans and
weak demand for commercial loans, banks did so to
boost capital ratios and improve the risk profile of
lending. This portfolio shift was particularly noticeable for banks with weaker balance sheets. In part
the shift was made possible by a reduction in nominal interest rates, which allowed the household
sector to increase its borrowing. In addition, the
concessional risk weighting of housing loans in the
risk-based capital standards introduced in 1988
gave reasons for banks with weak balance sheets to
move toward more housing loans.5 The improvement in the condition of banks’ balance sheets was
also aided by the widening of margins on housing
loans. However, this widening of margins also dampened credit growth because the high margins
reduced the demand for loans.
Overall, while evidence in the article indicates only
the existence of a credit-supply channel, it constitutes a circumstantial case that the loan losses of the
early 1990s played some role in retarding lending
growth, particularly of commercial loans in Australia.
Hence, supply-based contractions in aggregate loan
growth in Australia may have contributed nontrivially to the length and macroeconomic cost of the
observed credit contraction associated with the
1990–91 recession.
Bank Condition and Lending:
The Australian Experience
eregulation of the Australian financial system in the 1980s reduced constraints on
banks’ access to depositor funds and gave
banks the discretion to make price and quantity
decisions with regard to credit allocation.6 There
was a view that access to a broader funding base and
the ability to participate in a wider range of lending
D
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
activities would eliminate the practice of creditrationing among banks (Committee of Inquiry 1981;
Grenville 1991). The credit expansion of the late
1980s supported this view. Blundell-Wignall and
Gizycki (1992) estimate supply and demand for
business loans, finding no evidence of credit
rationing during the 1980s.
An alternative view emerged during the downturn
of the credit cycle. Some business commentators
argued that even in the deregulated environment of
the 1990s, banks were restricting the supply of
credit to creditworthy firms. The gist of the argument was that losses incurred by banks as a result of
ill-fated loans made in the 1980s had forced banks to
restrict lending to borrowers with otherwise viable
investment opportunities.
Despite the hypotheses offered in the popular
press, there has been little research examining the
relationship between bank lending and indicators of
bank condition among Australian banks. This article
is motivated by the notion that credit contractions
initiated by economic downturns are exacerbated
by banks’ subsequent reluctance to extend credit—
that is, economic downturns can increase borrower
defaults and impose large losses on banks’ consolidated operations. To the extent that banks must rely
on capital to absorb these loan losses, and to the
extent that raising additional capital is costly, they
are forced to curtail future lending and to reassess
the composition of their loan portfolios. The supply
response of banks is mixed, differing across banks
according to their respective capital positions.
The techniques used in U.S. studies cannot be
directly replicated using Australian banking sector
data. First, although information on capital adequacy
is available beginning in 1985, data on impaired
assets for Australian banks are available only from
TABLE 1
Shares in Bank Lending Markets
(Percentage of Total; Average over 1990–96)
Total loans
Commercial loans
Housing loans
Personal loans
Major
Banks
Regional
Banks
Foreign
Banks
68.48
61.98
71.60
80.61
22.79
21.69
25.12
15.85
8.73
16.33
3.27
3.54
Source: Reserve Bank of Australia Bulletin
1990 onward, leaving few data points for timeseries analysis. Second, the Australian banking sector is highly concentrated relative to that of the
United States; only thirty-one Australian banks
operated continuously during the downturn in the
1986–93 credit cycle, compared with many thousands of banks in the United States (see Berger,
Kashyap, and Scalise 1995, Appendix A, Table A1).
Australia’s four major banks, Australia and New
Zealand Banking Group (ANZ), Commonwealth
Bank of Australia (CBA), National Australia Bank
(NAB), and Westpac Banking Corporation (WBC),
account for around 70 percent of total bank lending
(see Table 1); the six U.S. money-center banks hold
only around one-quarter of U.S. commercial bank
assets. Therefore, data constraints for Australian
banks, along with the dominance of the four major
banks, limit the ability to replicate U.S. studies
meaningfully.
Although there is only limited scope for econometric analysis of the credit-supply channel in
Australia, direct analysis of bank reporting data
shows that Australian banks were subject to significant
loan losses during the early 1990s and that this
experience weakened their capital position.
1. This work was initiated while Tallman was a visiting senior research economist at the Reserve Bank of Australia. The views
expressed are those of the authors and should not be attributed to the Reserve Bank of Australia, the Federal Reserve Bank
of Atlanta, or the Federal Reserve System.
2. The effect is stronger for those banks that are capital-constrained, with capital ratios approaching the regulatory minimum.
The regulatory minimum is determined by capital adequacy guidelines, discussed below in the section on impaired assets and
capital ratios. Berger, Herring, and Szego (1995) also participate in the debate by asserting that the safety net associated with
deposit insurance weakens the relationship between capital and lending. This assertion implies the existence of moral hazard
problems, whereby banks covered by deposit insurance have less incentive to control risk exposures.
3. In addition, Hancock and Wilcox (1998) produce evidence that small banks in the United States shrank their loan portfolios
more than large banks in response to declines in their bank capital. By examining explicitly the transmission mechanism linking small bank loans to small firms, this research aims more directly at the question of how the supply-based credit contractions affect the real economy.
4. Basel risk-based capital standards were instituted in Australia on August 23, 1988 (see Thompson 1991, 141).
5. The Basel risk-based capital standards recommend that a housing loan has a risk weight that is half the risk of a commercial
loan. Hence, a bank faced with a choice between a commercial loan and a housing loan of the same amount would have to
hold only half as much capital for the housing loan as for the commercial loan.
6. Fisher and Kent (1999) show that the financial market in Australia changed dramatically prior to the 1890 financial crisis.
These observations suggest that intermediaries must learn to adjust to new powers and new environments.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
15
Extrapolating from U.S. results, these losses may
have reduced subsequent loan growth and extended
the contraction in credit beyond that associated
purely with a fall in demand for credit. A subsequent
section discusses this issue more fully.
The 1986–93 Credit Cycle
he 1986–93 credit cycle was Australia’s first
cycle in a deregulated environment. The key
features of this cycle, examined briefly in this
section, include
T
• a large increase, and then fall, in the ratio of
credit to gross domestic product (GDP);
• the increasing importance of banks relative to
other financial institutions;
• large losses by banks in the downswing of the
cycle;
• a narrowing, and then widening, of lending
margins; and
• a fall in loan growth and changes in portfolio
composition.
The Ratio of Credit to GDP. The ratio of credit
to GDP is a standard measure of intermediated
credit as a proportion of the aggregate economy. In
Australia, the ratio of intermediated credit almost
doubled over the 1980s, reaching a peak for the
1986–93 credit cycle of 0.9 in June 1990. Chart 1
shows that the credit expansion occurred primarily
in the second half of the 1980s following deregulation of the financial sector. The deregulation and
innovation in the financial market may have lowered
the price of intermediated credit. The expansion
coincided with an asset price boom and relatively
high inflation (Macfarlane 1991).7 Rising asset
prices increased collateral values, thus improving
the balance sheet position of borrowers and
enabling an increased demand for credit, to which a
deregulated Australian financial system was able to
respond. In 1990–91, however, the economy slid
into recession, and a sharp decline in credit followed.
The ratio of credit to GDP fell for three years, and it
took almost five years to reach its previous peak.
Chart 1 includes subcategory measures of business, housing, and personal loans, each of which
includes loans made by foreign subsidiary banks as
well as domestic Australian banks. The breakdown
shows that the 1986–93 credit cycle was driven primarily by the cycle in business credit. The ratio of
business credit to GDP more than doubled over the
1980s, reaching a peak of 0.57 in June 1990. The
downturn in aggregate credit also coincided with
that of business credit. In contrast, the ratio of housing credit to GDP remained fairly stable over the
1980s but increased steadily during the 1990s as
Australian households began to increase their comparatively low levels of debt (Stevens 1997).
Although the downturn in the ratio of credit to
GDP began in September 1991, the pace of credit
expansion had begun to slow a couple of years
earlier. Loan commitments are sometimes viewed
as a signal for future lending growth. This pattern
is observable in Australian data as well. Chart 2
shows that banks’ net lending commitments fell
substantially in 1989 and were weak in nominal
terms for the following two years, anticipating
the weakness in bank loan growth that took place
in 1990.8
The Importance of Banks. Although the economic expansion of the late 1980s stimulated strong
lending growth across all financial intermediaries,
the banking sector contributed most to the expansion in credit. Chart 3 shows real (inflation-adjusted)
growth in lending by financial intermediaries.9
Real growth in lending by banks increased sharply
between 1988 and 1990, briefly reaching annual rates
of almost 30 percent and averaging 21.5 percent over
the second half of the 1980s. This pace was considerably faster than the rate of growth in lending by all
financial intermediaries and faster than the growth rate
of M3 (which averaged 14 percent over the second
C H A R T 1 Ratio of Credit to Nominal GDP
1.0
Total Loans
Business Loans
0.6
Housing Loans
0.2
Personal Loans
1970
1980
Source: Credit measures, Reserve Bank of Australia Bulletin; GDP, Australia Bureau of Statistics
16
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
1990
C H A R T 2 Banks’ Net Lending Commitments
Billions of Australian Dollars
50
Total Loans
30
Commercial Loans
10
1985
1989
1993
1997
Source: Reserve Bank of Australia Bulletin
C H A R T 3 Real Growth in Lending by Financial Intermediaries
Banks
Percent
20
All Financial Intermediaries
0
1980
1990
1985
1995
Source: Reserve Bank of Australia Bulletin
half of the 1980s), as banks financed some of their
lending growth from abroad.10
Edey and Gray (1996) argue that deregulation led
to a one-shot expansion in the financial sector and
allowed banks to reassert their dominance as financial intermediaries. Prior to the mid-1980s, the
assets of nonbank financial institutions grew rapidly
relative to those of banks.11 Controls on bank
deposit and lending rates as well as on asset composition had left banks at a competitive disadvantage
(Battellino and McMillan 1989). The gradual
removal of those controls saw this disadvantage
diminish, with bank intermediation gaining strength
over the 1980s. Between 1985 and 1990, total assets
of banking institutions as a share of GDP rose from
57 percent to 88 percent (Edey and Gray 1996).
The rapid growth in bank lending following deregulation has some historical antecedents. For
Australia, Fisher and Kent (1999) describe the
Banking Crisis of 1893; they note that in the years
7. It is notable that the unequivocal policy recommendation from Boyd and others (2000) is that banking crises tend to occur
in environments of high inflation. They note that even predictable inflation is unhealthy for the financial system.
8. Net lending commitments are defined as bank offers to provide finance, minus cancellations of commitments; the duration of
commitments differs across borrowers. Between 1986 and 1993, banks’ net lending commitments averaged around 40 percent
of their loans outstanding to the private sector.
9. Lending by financial intermediaries comprises loans, advances, and bills held with the private nonfinancial sector.
10. Growth in bank lending and M3 is adjusted for the conversion of building societies (institutions similar to U.S. savings and
loans prior to 1989) to banks. M3 is currency plus bank deposits of the private nonbank sector, excluding commonwealth
and state government deposits and interbank deposits.
11. In many cases banks established nonbank subsidiaries in order to bypass regulatory constraints.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
17
prior to the crisis there was a notable growth in the
assets of intermediaries that could effectively compete
with trading (note-issuing) banks. In response, they
argue, banks then began acquiring a riskier portfolio
to maintain profitability. Given the seriousness of
the banking collapse of 1893 in Australia, it seems
clear that banks were relatively unprepared for the
rigorous credit assessment necessary for maintaining risky portfolios profitably. More recently, the
savings and loan institutions in the United States
grew rapidly upon gaining new powers in the early
1980s, and most Americans are well aware of the
requirements needed to recover from the loan
losses of savings and loan institutions.
The rapid growth in the loans among both U.S.
savings and loan institutions and Australian banks in
the 1980s exposed the underdevelopment of their
respective credit-assessment skills at that time. In
both cases, the institutions had operated in a constrained environment for many years and hence had
devoted insufficient resources to credit assessment
and the pricing of risk (see Ullmer 1997 for a discussion of the Australian case). As a result, when
deregulation relaxed constraints, Australian banks
were not well positioned to manage credit risk. With
pressure to regain market share, banks may have
extended loans that under other circumstances they
would not have made. Some anecdotal evidence in
support of this view is contained in ANZ’s 1992
annual report: “Undoubtedly, there was some
imprudent lending during the boom period of the
late 1980s, particularly in the small and medium
business sectors, where the battle for market share
following deregulation was hardest fought” (1992,
2). The end result was rapid growth in bank lending
and increasingly risky loan portfolios.
Large Losses for Banks in the Downturn of
the Credit Cycle. When the downturn in economic activity occurred, the previous rapid loan
growth came home to roost, so to speak, and indicated, ex post, the inadequacy of existing credit
assessment. There was a substantial increase in
the level of banks’ nonperforming loans accompanied by sharply falling profits and a sharp deterioration in the average return on shareholders’
funds, as shown in Chart 4. In fact, the average
return on shareholders’ funds in 1991–92 was negative, at –1.8 percent.
One indicator of Australian banks’ exposure to
nonperforming loans is the ratio of impaired assets
to capital. The data presented here are for net
impaired assets (total impaired assets less provisions held against specific loans; see Appendix A
for more details). This is a standard measure of the
vulnerability of banks’ capital to problem assets.
18
Chart 5 presents this measure for major, regional,
and foreign banks.12
The early 1990s recession in Australia contributed to the sharp increase in impaired assets
across all bank categories. For foreign and regional
banks, net impaired assets during 1991 were equivalent to their entire capital base. More importantly,
the net impaired assets of the major banks also
reached high levels in 1991, covering more than 60
percent of their capital base. Major bank impaired
assets remained high for a relatively long period; it
was not until late 1994 that the ratio of net impaired
assets relative to capital fell below 0.2.
Bank Lending Margins. Amid sizable loan
losses and a falling cash rate in the early 1990s, the
margin between bank lending rates and the cash
rate (the cost of funds) increased. The top panel of
Chart 6 shows the difference between the mortgage
rate and the cash rate and the difference between
the business indicator rate and the cash rate.13
Some background on the institutional structure of
the Australian financial market will help clarify the
significance of these figures. The cash rate in
Australia is analogous to the federal funds rate in
the United States; the cash rate represents the marginal cost of funds to the Australian banking system.
Also, the cash rate is the rate of interest set by the
Reserve Bank of Australia. During the 1986–93 period,
the typical mortgage in Australia did not have a
fixed interest rate. Instead, banks typically adjusted
the mortgage rate based on market conditions,
namely, some premium over the cash rate. In
essence, during the time period for the data in this
study, the mortgage rate paid in Australia was set
periodically by the bank holding the mortgage. Only
somewhat later did competitive pressure arising
from new mortgage providers reduce the power of
banks to dictate the mortgage rate.
The differential between lending rates and the
cash rate narrowed in the late 1980s as the cash rate
was increased and competitive pressures within the
financial sector also increased. Based on the business indicator rate, the differential associated with
commercial loans averaged around 2.5 percent
through the late 1980s but then widened to around
4 percent in 1991 and remained at this level for
almost three years. The housing-loan interest rate
spread followed a similar pattern over the 1990s, also
peaking at a little over 4 percent. Part of the explanation for this widening of interest rate margins
(measured relative to the cash rate) is that while
the cash rate fell substantially over this period,
banks’ average cost of funds did not fall to the same
extent (see Lowe 1995 and Reserve Bank of
Australia 1992). To maintain average margins, the
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
CHART 4
Average Return on Bank Shareholders’ Funds (Major Banks)
Percent
20
10
0
1980
1990
Source: Reserve Bank of Australia Bulletin; annual reports of major banks, various issues
C H A R T 5 Ratio of Net Impaired Assets to Capital
Regional Banks
1.0
0.6
Majors Banks
Foreign Banks
0.2
1990
1995
Source: Internal reports to Reserve Bank of Australia (Prudential Statements)
difference between lending rates and the cash rate
widened. One effect of this development was that it
made the writing of new loans, particularly housing
loans, more profitable.14 Undoubtedly, this increased
profitability was a factor underlying the rebound in
average returns on shareholders’ funds, which
returned to almost 15 percent only two years after
reaching negative levels in 1991–92.
Contraction in Lending and Large Portfolio
Shifts. Although the asset portfolios of major,
regional, and foreign banks exhibit the same general response to losses in the early 1990s, there are
differences in the timing and magnitude of lending
responses across these categories. Chart 7 presents
growth in total loans and commercial loans across
bank categories, adjusted for breaks in lending
12. The sample consists of the thirty-one banks that traded continuously during the downturn in the 1986–93 credit cycle.
There are four major banks, eleven regional banks, and sixteen foreign banking subsidiaries; their shares of total bank lending are 70 percent, 20 percent, and 10 percent, respectively. For more details, see Table 1 and Appendix B.
13. The standard variable rate on bank housing loans is taken as a measure of the mortgage rate on housing loans. The commercial lending rate is given by the business indicator rate on banks’ large, variable-rate business loans.
14. High levels of profitability also encouraged mortgage managers to enter the market and contributed to the narrowing of margins evident in the mid-1990s.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
19
C H A R T 6 Bank Lending Margins (Major Banks)
Business Indicator Rate Less Cash Rate
Per cent
4
2
Mortgage Rate Less Cash Rate
0
1990
1995
Per cent
18
14
Cash Rate
10
6
1990
1995
Source: Reserve Bank of Australia Bulletin
series. These breaks are the result of bank reclassifications and the transfer of loans to or from intermediaries outside the category under consideration.
Foreign banks suffered the most rapid and
extreme decline in total lending, with loan
growth becoming negative in 1992.15 Growth in
regional banks’ total loans also fell during 1991
but fluctuated at positive rates of between 10
percent and 15 percent. Despite the fact that
growth in major banks’ total loans remained positive, reaching a trough of 2 percent in 1992,
major bank lending only began a sustained recovery in 1994.
The chart shows that the decline in commercial
loan growth was more uniform across bank categories. Growth in commercial lending suffered a
more extreme fall than growth in total loans.
During 1991, growth in commercial loans fell from
25 percent to around 10 percent for both regional
and foreign banks. Foreign banks’ commercial loan
growth became negative in 1992, with the decline
in lending continuing until 1994. Major banks also
reduced commercial lending in the early 1990s,
with growth becoming negative in late 1992.
Growth in commercial lending remained weak for
an extended period, only showing signs of recovery
in 1995.
20
Sizable changes in bank loan growth over the
1986–93 credit cycle were accompanied by substantial shifts in the composition of banks’ lending
portfolios. Chart 8 presents the loan portfolio
composition of major and regional banks, respectively. Portfolio shares in commercial, housing,
and personal loans combined account for almost
100 percent of total loans, the residual being lending to government. Sharp changes in portfolio
shares, such as that of commercial loans in the
regional bank portfolio in 1992, can be explained
by breaks in lending series. These breaks are listed
in Appendix C.
For major and regional banks, the most notable
trend is the steady decline in the share of commercial lending and the corresponding increase in the
share of housing loans. By 1995, housing loans
accounted for more than 50 percent of major bank
lending, compared with 40 percent in 1992. The
shift toward housing loans was even more marked
for regional banks, with the share of housing loans
increasing from around 40 percent in 1992 to a
share of 65 percent by the end of 1996. This shift
from commercial loans to housing loans following
large losses is consistent with the analysis of U.S.
banks presented in Kaufman (1992) and Hancock,
Laing, and Wilcox (1995). But, as will be discussed
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
CHART 7
Loan Growth across Bank Categories (Percentage Change over Four Quarters)
Commercial Loans
To t a l L o a n s
Per centage Change
40
Foreign
Regional
20
Regional
Major
0
Major
Foreign
1991
1995
1991
1995
Source: Reserve Bank of Australia Bulletin
CHART 8
Portfolio Composition of Major Banks and Regional Banks (Percentage of Total Loans)
Major Banks
Regional Banks
Per centage
70
Housing
50
Housing
30
Personal
Commercial
10
Commercial
Personal
1990
1990
1995
1995
Source: Reserve Bank of Australia Bulletin
below, the shift toward housing loans was further
reinforced by the lower risk-weighting given these
loans by the Basel standards.
The 1986–93 credit cycle was one of the more
pronounced cycles experienced in Australia’s history. In part, it can be explained as a by-product of
the transition from a highly regulated financial system to a deregulated system. The cycle saw banks
contribute significantly to the increase in lending
during the late 1980s but incur large losses in the
downswing of the cycle. There was a subsequent
widening of lending margins and a decline in banks’
loan growth during the early 1990s. Furthermore,
there was a distinct shift in banks’ loan portfolio
composition away from commercial lending and
into housing loans. The analysis in the next section
suggests that the characteristics of the 1986–93
credit cycle are consistent with the existence of a
credit-supply channel.
The Credit-Supply Channel
hile the downturn in the credit cycle saw a
significant fall in banks’ loan growth and
major changes in the structure of
Australian bank portfolios, it is not immediately
clear whether these changes were driven by the
demand for credit or a combination of demand and
supply factors. The discussion now turns to the relationship between loan losses and capital positions
across individual banks and the subsequent changes
in those banks’ portfolios. Analysis is predicated on
the assumption that all banks face broadly similar
demand conditions so that differences in the size
and composition of bank assets reflect decisions
W
15. Some observers viewed the losses among these banks as a transfer from overseas banks to Australian borrowers.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
21
made by individual banks. Factors underlying
these decisions are loosely referred to as supplyside influences.
It is important to acknowledge the difficulty in
identifying credit-demand versus credit-supply
channels. For example, the fall in banks’ net lending
commitments beginning in 1988 no doubt reflects a
fall in demand for credit due to high interest rates.
However, reduced commitments may in part also be
a supply-side initiative, with banks recognizing that
the prevailing growth in lending was not sustainable
and that high interest rates would impose financial
constraints on borrowers. Similarly, alternative
explanations can be offered for the extended weakness in commercial lending commitments during the
first half the 1990s (see Chart 2).
Restructuring of business and substitution away
from debt financing undoubtedly reduced demand
for commercial credit, but substantial loan losses
may also have reduced banks’ willingness to make relatively high-risk commercial loans. The Commonwealth Bank describes the contribution of demand
and supply factors: “It is important to stress that the
Bank (CBA) remains willing to lend—it is the lack of
demand and, to a lesser extent, the absence of
viable proposals, that is determining current lending
levels” (CBA 1992, 7). The existence of the creditdemand channel is widely accepted, and, although
far from conclusive, evidence does suggest that the
credit-supply channel was active during the downswing of the 1986–93 credit cycle.
This article analyzes primarily the data for
Australia’s four major banks because these banks
account for the bulk of bank-intermediated lending,
provide relatively consistent data, and have comparable market shares (see Table 2). Also, the assumption that demand conditions are broadly similar
across banks is probably more accurate for the
major banks, each having national coverage and
extensive branch networks, than for a more diverse
grouping of financial institutions. Even so, the
assumption is unlikely to hold exactly. Large loan
losses are often the result of borrowers who take out
large loans and default on loan repayments. To the
extent that customer markets exist, demand for
loans from a bank with large loan losses might be
significantly reduced because defaulting borrowers
are unlikely to be borrowing additional funds. On
the other hand, major banks have a long-established
history in financial intermediation and they have
banking relationships with a wide range of clients,
so if one group of customers has reduced demand
for loans, new customers can be attracted from
other banks.
Facts on the Major Banks. In order to examine
the relationship between loan losses and subsequent lending behavior, measures of bank condition—namely, impaired assets and capital—are
obtained from the major banks’ annual reports while
lending data are those collected by the RBA.16
Impaired Assets and Capital Ratios. Data on
impaired assets reflect the actual and potential losses of a bank. Up until 1994 each bank tended to
disclose a slightly different measure of impaired
assets in its annual report.17 Although the figures
are not strictly comparable across banks and may
over- or understate the true level of problem
assets, they are presented here as an indication of
the relative size of problem loans across major
banks and the change through time in problem
assets within each of the major banks.
Chart 9 shows that for each of the major banks,
the ratio of net impaired assets to capital peaked in
1991 or 1992. Each of these banks had nonbank subsidiaries that contributed to losses.18 WBC experienced the most marked deterioration in asset
quality with net impaired assets in 1992 being equivalent to around 70 percent of its capital base. These
problem loans contributed to a net after-tax loss of
$1,562 million in 1992. ANZ also suffered high levels
of net impaired assets, which in 1991 amounted to
almost 60 percent of capital. The peak in ANZ’s
impaired assets was also associated with a net aftertax loss of $579 million in 1992. Although CBA’s net
impaired assets also covered a substantial proportion of its capital base in 1991, CBA managed to
maintain positive after-tax profits. More notable,
however, is the performance of NAB, whose net
TABLE 2
Shares in Major Bank Lending Markets (Percentage of Total; Average over 1990–96)
Total loans
Commercial loans
Housing loans
Personal loans
ANZ
CBA
NAB
WBC
20.69
25.71
17.60
18.79
28.84
24.59
34.58
23.75
25.92
29.65
20.27
32.94
24.55
20.06
25.55
24.51
Source: Internal reports to Reserve Bank of Australia (Prudential Statements)
22
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
CHART 9
Measure of Major Bank Condition
ANZ
(as of September 30)
CBA
(as of June 30)
Ratio of Net Impaired Assets to Capital (RHS)
0.5
Ratio
Per cent
15
10
0.1
Capital Ratio (LHS)
1990
1990
1995
NAB
(as of September 30)
1995
WBC
(as of September 30)
0.5
Ratio
Per cent
15
10
0.1
1990
1995
1990
1995
Note: Capital ratio is percent of total risk-weighted assets.
Source: Annual reports of major banks
impaired assets were modest in comparison, peaking at 30 percent of capital in 1991.
The high levels of impaired assets experienced in
1991 and 1992 reflect a concerted effort on the part
of banks to undertake a one-time write-off of problem loans in order to improve their balance sheet
positions. This action would in part explain the
rapid decline in net impaired assets after 1992, particularly for WBC and ANZ, whose ratio of net
impaired assets to capital was halved within two
years of its peak.
In addition to impaired asset data, Chart 9 presents
capital ratios across the major banks as another
measure of bank condition. Conforming with international supervisory arrangements established by
the Basel Accord, Australian banks have been subject to minimum capital requirements since August
1988. Capital adequacy guidelines stipulate that
each Australian bank is expected to maintain a
minimum ratio of capital to risk-weighted assets of
8 percent. Capital base is defined as tier 1 capital
plus tier 2 capital, less goodwill and future income
tax benefits. For detailed definitions see Appendix A. Risk-weighted assets are calculated by applying
a 0 percent weight on gold and cash balances with
the RBA, a 10 percent weight on federal and state
16. For confidentiality reasons, present capital adequacy and impaired asset data on individual banks as collected by the
RBA are not presented. The measures taken from bank annual reports are year-end figures and do not reflect withinyear variability.
17. In September 1994 the RBA provided banks with a set of guidelines for the definition of impaired assets, facilitating consistent reporting across banks. Impaired assets are defined as the sum of nonaccrual items, restructured items, other real
estate–owned items, and other assets acquired through enforcement. See Appendix A for further details.
18. These losses are attributed to major banks’ large exposures in the commercial property market. Conroy (1997) argues that
in many cases subsidiaries failed to properly consult the lead bank when increasing their stake in property development.
WBC subsidiaries Australian Guarantee Corporation (AGC) and Partnership Pacific Limited (PPL) made losses of $107 million and $146 million, respectively, in 1992. PPL also made losses of this magnitude in 1990 and 1991. ANZ’s finance company, Esanda, made losses of $139 million in 1992.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
23
government securities and claims on governments
and central banks of Organisation for Economic
Cooperation and Development (OECD) countries,
a 20 percent weight on local government securities
and claims held against Australian and OECD
banks, a 50 percent weight on mortgage-backed
lending, and a 100 percent weight on commercial
and foreign assets. Personal loans that are not
mortgage-backed also attract a 100 percent risk
weight. Lower risk weights are associated with
assets that are typically assumed to be less subject
to credit risk.
Chart 9 shows that the peak in impaired assets in
1991 and 1992 generally coincided with reductions
in capital ratios. The coincident peaks are most
apparent for both WBC and ANZ, whose comparatively large losses were associated with a fall in
their capital ratios of almost 1 percentage point, to
9.7 percent and 9.0 percent, respectively. The fall in
CBA’s capital ratio was of lesser magnitude while
NAB maintained a fairly constant capital ratio of
around 11.5 percent in 1991 and 1992. After 1992,
capital ratios increased quite quickly. In the case of
WBC, capital relative to risk-weighted assets
increased from 9.7 percent in 1992 to 13.8 percent
in 1994. ANZ, being subject to the second-largest
losses among the major banks, also significantly
increased its capital ratio between 1992 and 1994,
from 9.0 percent to 11.3 percent.
As the following equation shows, changes in a
bank’s capital ratio can be decomposed into three
elements: changes in the bank’s capital, changes in
the bank’s total assets, and changes in the composition of those assets. The capital ratio is defined as
k=
K
,
A*
(1)
where K is the capital base and A* is risk-weighted
assets. For simplicity it is assumed that there are
two assets and that one of the assets has a concessional risk weight of θ while the other has a risk
weight of one. Therefore,
A* = θ A1 + A2 0 ≤ θ < 1,
(2)
where A1 and A2 are the two assets. This calculation
can also be expressed as
A* = [1 – w(1 – θ)] A,
(3)
where A is total assets ( A1 + A2 ) and w is the portfolio
share of the asset attracting the lower risk weight.
Substituting (3) into (1) and totally differentiating yields
24
dk =
(
)
1−θ
.
dk
−
k
A
+
k
A*
1 − w 1 − θ
(
)
dw ,
(4)
where a dot (·) above a variable denotes a percentage change.
Equation (4) implies that the capital ratio will
increase if capital increases, if total assets decline,
or if there is a portfolio shift toward the asset with
the concessional risk weight. The lower the concessional risk weight (θ) is, the larger the effect will be
on the capital ratio of a given change in the structure of a bank’s portfolio. As will be discussed below,
portfolio reallocation played an important role in the
improvement of capital ratios among Australian
banks in the 1990s.
Lending Behavior. Chart 10 shows total loan
growth and commercial loan growth for each of the
major banks during the 1990s. Consistent with data
published by the RBA, total loans are defined as
lending to the nonfinancial sector. The lending figures presented here are those of the lead bank, and
all growth rates are break-adjusted. The most
notable adjustments occur for CBA in January 1991,
given its acquisition of State Bank of Victoria, and
for WBC in October 1996 when its subsidiary,
Challenge Bank, transferred the bulk of its loans to
the lead bank.
As Chart 10 indicates, following the peak in
impaired assets in 1991 and 1992, each of the major
banks experienced substantially slower loan growth.
The contraction in commercial lending was generally
more extreme and relatively extended compared
with the contraction in total loans. Slow growth in
major bank lending can in part be explained by
reductions in net lending commitments, which
occurred prior to the realization of loan losses.19
Having absorbed the largest losses among the
major banks, WBC suffered the deepest and most
extended contraction in commercial lending. The
contraction in lending, however, was preceded by a
brief period of rapid loan growth in 1992. This
growth spike largely reflects changes in WBC’s holding of bank bills in 1991 and 1992. Excluding the
“bills held” component of lending shows that commercial loan growth was negative in 1992 (see
Appendix A for more details).
Consistent with the established definition of commercial lending (including bills held), Chart 10
shows that growth in WBC commercial loans was
consistently negative between 1993 and 1995, averaging around –8 percent. The contraction in ANZ
commercial lending was less severe but followed the
same broad pattern as that of WBC. However,
growth in ANZ total loans was weaker than that of
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
CHART 10
Growth in Major Bank Lending (Percentage Change over Twelve Months)
CBA
ANZ
Percentage change
30
Total Loans
10
Commercial
–10
1991
1995
1991
WBC
NAB
Per centage change
1995
30
10
–10
1991
1995
1991
1995
Source: Reserve Bank of Australia collected data
WBC. Total lending by CBA recovered slowly from
1993 onward. The contraction in CBA commercial
lending was of a smaller scale than that experienced
by WBC and ANZ, but the weakness in loan growth
was relatively extended. Compared with the other
major banks, NAB lending emerged strongly from
the economic downturn, with a moderate slowdown
in commercial lending. NAB total loan growth fell in
1991 but rebounded in late 1993, reaching 20 percent within a year; NAB commercial loan growth
was positive and increasing during 1994, despite the
contraction in commercial lending experienced by
the other major banks. Charts 9 and 10 combined
suggest that the banks that suffered most acutely
from large loan losses in the early 1990s, namely,
WBC and ANZ, were subject to deeper and more
extended contractions in commercial lending as
they were rebuilding capital ratios.
Composition of Loan Portfolios. Australian
banks made a distinct substitution out of commercial lending and into housing loans in the aftermath
of the recession of 1990–91. Consistent with the
aggregates in Chart 8, Chart 11 shows a marked
shift in portfolio composition among individual
major banks.20 Those banks subject to the highest
impaired asset levels made an aggressive shift out of
commercial lending and into housing loans. For
example, housing loans accounted for almost 60
percent of the WBC lending portfolio by 1995, compared with 40 percent in 1992; the share of commercial loans fell from almost 40 percent to 25
percent over this period. Similarly, by 1995 housing
loans accounted for 50 percent of the ANZ loan
portfolio, compared with 35 percent in 1992, with
the share of commercial loans falling from around 50
percent to 40 percent. CBA and NAB have also
19. Net lending commitments across the major banks are consistent with trends shown in Chart 2. Commitments turned down
in 1988 and remained relatively weak for commercial lending in particular. Commitments data also confirm that weak loan
growth was not simply the result of nonperforming loans being written off. Net lending commitments made by banks in weak
condition were relatively low between 1991 and 1995, especially in the market for commercial loans. In contrast, NAB commitments recovered steadily from 1992 onward.
20. Once again, the sum of portfolio shares in commercial, housing, and personal loans accounts for almost 100 percent of total
loans. Sharp changes in portfolio shares can be explained by breaks in lending series. These breaks are listed in Appendix C.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
25
CHART 11
Portfolio Composition of Major Banks (Percentage of Total Loans)
CBA
Per centage
ANZ
50
Commercial
Housing
10
Personal
1990
1995
Per centage
1995
1990
NAB
WBC
50
10
1990
1990
1995
1995
Source: Reserve Bank of Australia collected data
devoted an increasing share of their portfolios to
housing loans over the 1990s, with a moderate substitution away from commercial lending.
Some Evidence of a Credit-Supply Channel.
Chart 12 relates impaired assets across the four
major banks to average growth in risk-weighted
assets in the two years after the peak in impaired
assets and average growth in total loans over the
same period. Average growth in risk-weighted
assets is calculated based on annual report data,
that is, publicly available information, while growth
in total loans is based on data reported to the RBA.
Impaired assets, rather than net impaired assets, are
taken as the point of reference given that exposure
to problem loans (provisioning aside) is likely to
prompt an internal review of lending policies.
Chart 12 makes it apparent that the banks with a
higher ratio of impaired assets to capital generally
experienced relatively large contractions in riskweighted assets and loan growth, observations generally interpreted and viewed as a shift by banks out of
risky assets. The left-hand panel of Chart 12 shows
that WBC, being most exposed to impaired assets,
experienced an annual change in risk-weighted
assets of around –12 percent in the two years following
the peak in impaired assets. Only NAB experienced a
significant increase in risk-weighted assets, with
26
growth averaging almost 10 percent per annum
following the peak in impaired assets. The right-hand
panel of Chart 12 shows that total loan growth
remained positive for each of the major banks but
was particularly strong for NAB, it having been the
least exposed to impaired assets.
Given that average growth in total loans for each of
the major banks was positive, any reduction in riskweighted assets was due to changes in banks’ balance sheet structure—a shift toward assets that
attract a concessional weight in the calculation of
risk-weighted assets. Thus it is not surprising that
banks with the largest losses, and subsequent contraction in risk-weighted assets, exhibited the largest
shift toward assets with a concessional risk weight.
Chart 13 relates impaired assets across the major
banks to the percentage point change in the ratio of
housing loans to total loans two years after the peak
in impaired assets. As suspected, those banks with
the largest losses (ANZ, WBC) shift most aggressively toward assets with concessional risk weights. The
chart shows that WBC, with the most sizable reduction in risk-weighted assets, undertook the most significant shift in portfolio composition. WBC, closely
followed by ANZ, substituted most strongly into
housing loans, which attract a risk weight of 50 percent as opposed to 100 percent on commercial loans.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
CHART 12
Major–Bank Asset Growth Two Years after the Peak in Impaired Assets
(Average Annual Growth)
R i s k - We i g h t e d A s s e t s
To t a l L o a n s
10
10
NAB
Per cent
NAB
0
6
ANZ
CBA
WBC
ANZ
CBA
2
–10
WBC
0.4
0.8
0.6
1.0
0.6
0.4
1.0
0.8
Peak in Impaired Assets Relative to Capital
Source: Annual reports of major banks; Reserve Bank of Australia collected data
CHART 13
Percentage Point Change
Major–Bank Portfolio Shifts Two Years after Peak in Impaired Assets
(Ratio of Housing Loans to Total Loans)
14
WBC
ANZ
10
NAB
6
CBA
2
0.4
0.5
0.6
0.7
0.8
0.9
1.0
Peak in Impaired Assets Relative to Capital
Source: Annual reports of major banks; Reserve Bank of Australia collected data
WBC and ANZ also experienced the largest corresponding shifts away from commercial lending, with
the portfolio share of commercial loans falling
around 9 percentage points and 8 percentage points,
respectively (see Chart 11). NAB made a strong shift
toward housing loans while the portfolio share of
commercial loans declined by 4 percentage points.21
Using the simple model discussed above, one can
obtain a rough guide to the importance of the shift
from commercial lending into housing loans in
improving capital ratios. It is assumed that housing
loans initially account for 40 percent of total loans (that
is, w = 0.4), rising to 60 percent (so that dw = 0.2).
The concessional weight on housing loans is known to
be 50 percent (that is, θ = 0.5). Furthermore, the initial capital ratio (k) is assumed to be 0.1, with the capital
. base and total assets held constant (dK = 0 and
A= 0). The resulting change in risk-weighted assets is
.
. 1−θ
A* = A −
1 − w 1 − θ
1
=−
dw
2−w
(
)
dw
(5)
= −0.125
21. CBA’s impaired assets peaked in 1991, but it is not until 1994 that the shift toward housing loans became apparent. As such,
Chart 13, which is based on lending two years after the peak in impaired assets, does not capture this shift.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
27
Thus, the assumed change in portfolio composition reduces risk-weighted assets by 12.5 percent.
With no change in capital base or total assets, equation (5) implies that an increase in the portfolio
share of housing loans from 40 percent to 60 percent will increase the capital ratio from 10 percent
to 11.25 percent. For banks that suffered extreme
loan losses and weakened capital condition, the
more marked substitution toward housing loans
served to reduce risk-weighted assets, thereby
boosting capital ratios.
More fundamentally, however, loan losses
caused banks to reassess portfolio allocations
among assets in different risk classes. Banks were
apparently less willing to absorb the heterogenous
risks associated with commercial loans when lowrisk housing loans could be issued at similar margins. This approach was reinforced by the fact that
mortgage-backed loans attract a concessional risk
weighting in the calculation of risk-weighted
assets. Given that the risk-based capital standards
were introduced in 1988, it does not appear that
the introduction of those standards alone generated
the dramatic portfolio shift, but it was clearly a
contributor. In essence, the question becomes one
of whether banks altered risk-weighted assets to
maintain capital ratios or whether large losses
motivated banks to become more active risk managers when making loans. Both reflect supplybased credit responses.
Interpretation of the Evidence
ollowing the economic downturn and the collapse of the credit boom in the early 1990s,
there was an extended contraction in bank
lending among Australian banks. In large part this
reaction reflected the unwinding of rapid increases
in corporate leverage during the 1980s. High interest rates, high leverage, and weak economic growth
saw a significant decline in the demand for loans.
However, there is some indication that the contraction in lending was reinforced by supply-based constraints. There is evidence of a relationship between
measures of bank condition and bank lending, with
those banks subject to the largest loan losses having
experienced larger-than-average declines in lending
growth and substantial changes in the composition
of their portfolios. This outcome is consistent with
the view that the decline in loan growth in part
reflected banks’ reluctance to lend in light of the
deterioration in the quality of their balance sheets.
Although WBC, for example, stresses that it in no
way sought to restrict lending, its 1991 annual
report states, “Following the rapid asset growth of
the 1980s, we have managed our balance sheet very
F
28
tightly, a process more recently facilitated by the
reduction in credit demand in Australia” (1991, 5).
Reduced loan growth may also be a decision on the
part of banks to control risk-weighted assets in
order to lift capital ratios.
Weak loan growth was combined with a change in
the composition of banks’ loan portfolios away from
commercial lending and into housing loans. In large
part this shift was made possible by strong demand
for housing loans as the economy emerged from
recession. The portfolio shift was, however, more
marked for banks in relatively weak balance sheet
condition. The ability of banks to undertake large
changes in portfolio composition was an important
element in the recovery of banks’ balance sheets.
This portfolio shift had two effects. First, it
allowed banks to increase capital ratios by reducing
risk-weighted assets given that housing loans attract
a lower risk weight of 50 percent compared with the
100 percent risk weight on commercial loans.
Second, portfolio substitution allowed banks to
reduce their exposure to commercial loans, which
are inherently riskier than housing loans. More
specifically, however, the shift toward housing loans
also stimulated a recovery in the profitability of
Australian banks. Increased margins on lending
helped restore profitability following the loan losses
of the early 1990s. Between 1992 and 1994, margins
on housing loans reached their highest level at
around 4 percent, equal to the margin on commercial loans.
In part, the portfolio reallocation undertaken by
banks was made possible by falling nominal interest
rates. The consequent reduction in mortgage lending rates, to interest rate levels well below those of
the 1980s, encouraged households to increase their
indebtedness and hence augmented their demand
for housing finance (see Stevens 1997).22 Australian
banks were fortunate that there was a ready
demand for low-risk, high-yielding housing loans.
Meeting this demand meant that banks were able to
generate higher returns with lower risk while simultaneously improving their capital ratios. Banks in
other countries, such as the United States and
Japan, also faced large loan losses during the 1990s.
However, banks in these countries were not in the
same fortunate position as the Australian banks. In
the United States, banks were forced to shift into
lower-yielding Treasury securities for some time
before their balance sheets recovered. Japanese
banks are still working to recover. In contrast,
Australian banks enjoyed a strong demand for a
concessionally weighted asset that was also relatively
high-yielding, thereby speeding the recovery of
Australian banking.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
Conclusion
his article analyzes the relationship between
measures of bank condition and bank lending
during the downswing in the Australian credit
cycle of 1986–93. The concentrated nature of the
Australian banking sector and a short data history
mean that conclusions are based on direct observation
of the data rather than econometric tests. While
changes in the demand for loans clearly account for
much of the cycle in credit growth, the analysis
describes evidence consistent with the hypothesis
that the sizable losses Australian banks incurred in the
early 1990s played at least some role in constraining
the availability of funds for commercial lending.
The basic conclusion from the Australian experience is that there is a relationship, albeit a relatively
weak one, between the loan loss experience of the
early 1990s and subsequent lending behavior. In
essence, the conclusions imply that the larger the
losses of a particular bank are, the slower its subsequent loan growth tends to be and the larger the
change in its balance sheet structure toward housing loans tends to be. This description of the
Australian data is consistent with the view that a
bank’s recent profitability (and its capital position)
can affect its lending decisions. The bank losses also
contributed to an increase in interest rate margins,
which in turn constrained the demand for loans. The
fall in lending, combined with the portfolio reallocation away from commercial lending and into housing
loans, served to increase capital ratios by reducing
risk-weighted assets. The shift toward housing loans
also gave banks the opportunity to restore profits
with a relatively low-risk, high-yielding asset, given
T
that margins on housing loans were similar to those
on commercial loans.
What is less clear is whether the reduced supply
of loans from banks with recent weak performance
was compensated for by additional loans from banks
with stronger profit performance. However, even if
other banks did compensate through an increased
supply of loans, the widening of lending margins
that followed the banking problems is still likely to
have reduced loan demand and thus credit growth.
Australian bank lending between 1986 and 1993 is
of particular interest because it was the first credit
cycle following financial deregulation in that country. Emerging from a regulated era, Australian banks
had limited experience in managing portfolios with
a rapidly increasing proportion of risky commercial
loans. Batellino and McMillan (1989) argue that
deregulation encouraged banks to be active liability
managers. However, deregulation and the following
credit expansion required that banks also become
active asset managers; they were now exposed to
risks that had not been on the balance sheet during
the regulated era.
As numerous examples in a range of countries
over the past decade illustrate, one can argue that
large losses by financial institutions can exacerbate
economic downturns. Given that developments in
the real economy can affect the financial sector, and
that developments in the financial sector can affect
the real economy, monetary policy must account for
changes in the pattern of financial intermediation.
Understanding the linkages between the real economy
and the financial sector remains a major challenge
for macroeconomic policymakers.
22. In addition, relatively low inflation ensured that repayment burdens in the early phase of a loan were lessened, making
borrowing more feasible for low-income earners.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
29
A P P E N D I X
A
Construction of Banking Data
Bank Lending
Measures of Bank Condition
B
The Capital Adequacy Return and the Impaired Assets
Return are used to construct measures of bank condition
for major, regional, and foreign bank categories.1 Both
returns are quarterly, and both are completed on a
consolidated group basis. (For confidentiality reasons,
annual report data are used when presenting capital
ratios and impaired assets for individual banks.)
The Capital Adequacy Return is used to construct
the following series:
alance sheet data are used to generate lending
series based on banks’ reporting to the RBA in
Form D. Form D is a weekly return that covers assets
and liabilities on Australian books. These data are used
to construct the following series:
• Total loans, defined as lending to the nonfinancial
sector.
• Commercial loans, defined as the sum of bills
held, other promissory notes, commercial fixed
loans, leasing finance, commercial overdrafts, commercial charge cards, and commercial other loans.
• Housing loans, defined as the sum of secured
owner-occupied housing, unsecured owner-occupied
housing, and non-owner-occupied housing.
• Personal loans, defined as the sum of personal
fixed loans, personal overdrafts, personal charge
cards, and other personal loans.
The “bills held” item is included in the definition of
both commercial and total lending. A client in need of
finance may approach its bank with a request to draw
a bill. Should the bank choose to hold the bill, it is
reported as bills held in Form D. Alternatively, if the
bank chooses to accept the bill but subsequently sells
it to another bank, the bill is still reported as an asset
(with an offsetting liability) but is not included in the
definition of lending. As in the case of WBC, the treatment of bills as a lending item or a separate asset can
affect growth rates. To illustrate, the chart presents
growth in WBC lending, excluding bills held.
• Capital base, defined as tier 1 capital plus tier 2
capital less goodwill and future income tax benefits. Tier 1 capital includes paid-up ordinary shares,
nonrepayable share premium accounts, general
reserves, retained earnings, noncumulative irredeemable preference shares, and minority interests
in subsidiaries consistent with the foregoing components. Tier 2 capital is supplementary capital. It
is classified as (1) upper tier 2 capital: general provisions for doubtful debts, asset revaluation
reserves, cumulative irredeemable preference
shares, mandatory convertible notes, and perpetual
subordinated debt; and (2) lower tier 2 capital:
term subordinated debt and limited life redeemable
preference shares.
• Total risk-weighted assets are a regulatory measure
of assets. It is with respect to this measure that the
minimum capital requirement is defined. The concept of risk-weighting assets is designed to provide
capital concessions to those banks that hold relatively
less risky assets.
Growth in WBC Lending (Excluding Bills Held)
(Percentage Change over Twelve Months)
Per centage Change
30
20
Total Loans
10
Commercial Loans
0
–10
1991
1995
Source: Prudential Reports of Reserve Bank of Australia; Westpac Banking Corporation annual reports
30
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
Prior to September 1994, impaired assets were
reported as “Nonperforming, Renegotiated, and
Doubtful Items,” for which data began being collected
in June 1990.2 The Impaired Assets Return is used to
construct the following series:
• Total impaired assets, defined as the sum of
nonaccrual items, restructured items, other real
estate–owned items, and other assets acquired
through security enforcement. Nonaccrual items
are those assets for which the bank does not expect
further returns and hence cannot accrue income
ahead of receipt. Restructured items are contracts
that have been modified to provide concessions for
the borrower.
• Special provisions, defined as those provisions held
against individually identified exposures if there is
doubt surrounding collectibility. Special provisions
can be held against both nonaccrual and restructured items.
1. Guidelines for the Capital Adequacy Return and Impaired Assets Return are detailed in Prudential Statements C1 and L1,
respectively.
2. The Impaired Assets Return is based on RBA definitions as opposed to the Nonperforming, Renegotiated, and Doubtful Items
Return, which is based primarily on banks’ subjective definitions.
A P P E N D I X
B
Sample of Australian Banks
Major Banks
ending series for each major bank are constructed
based on lending by the lead bank. When trading
and savings banks operate as separate entities, their
lending series are combined.
Australia and New Zealand Banking Group
Limited (ANZ) is combined with Australia and New
Zealand Savings Bank between January 1990 and
June 1992.
Commonwealth Bank of Australia (CBA) is combined with Commonwealth Savings Bank between
January 1990 and December 1992.
National Australia Bank Limited (NAB) is combined with National Australia Savings Bank between
January 1990 and September 1992.
Westpac Banking Corporation (WBC) is combined
with Westpac Savings Bank between January 1990 and
September 1993.
L
Regional Banks
Advance Bank Australia Limited (ADV)
Banks of Melbourne Limited (BML)
Bank of Queensland Limited (BQL)
Bank of South Australia (BSA)
BankWest Australia Limited (BWA)
Challenge Bank Limited (CBL)
Macquarie Bank Limited (MBL)
Metway Bank Limited (MET)
Primary Industry Bank of Australia Limited (PIB)
State Bank of New South Wales (SBN)
Trust Bank (TBT)
Foreign Banks
Bank of America Australia Limited (BAL)
Barclays Bank Australia Limited (BBA)
Banque Nationale de Paris (BNP)
Bank of China (BOC)
Bank of Singapore Australia Limited (BOS)
Bank of Tokyo Australia Limited (BOT)
Bankers Trust Australia Limited (BTA)
Chase Manhattan Bank (CMB)
Citibank Limited (CTI)
Deutsche Bank Australia Limited (DBA)
Hong Kong Bank of Australia Limited (HBA)
IBJ Australia Bank Limited (IBJ)
Lloyds Bank Limited (LBL)
Mitsubishi Bank of Australia (MBA)
NatWest Australia Bank Limited (NWA)
Standard Chartered Bank Australia Limited (SCB)
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
31
A P P E N D I X
C
Breaks in Lending Series
Portfolio Composition of Major Banks and
Regional Banks
hifts in portfolio composition shown in Chart 8
can be explained by the following breaks in
lending series:
S
(1) In September 1990, the change in major banks’
portfolio composition reflected one bank’s reclassification of certain personal and government loans
as housing and commercial loans.
(2) In January 1991, major banks shifted out of commercial loans and into housing loans as a result of
the acquisition of State Bank of Victoria by CBA.
(3) In July 1992, the share of commercial loans in the
regional bank portfolio dropped as a result of one
bank’s reclassification of certain commercial loans
as government loans.
(4) In July 1994, the share of personal loans in the
regional bank portfolio dropped as a result of
one bank’s reclassification of certain personal
loans as commercial loans.
32
Portfolio Composition of Major Banks
Shifts in major bank portfolio composition, as presented in Chart 11, can be explained by the following
breaks in lending series:
(1) In November 1991, there was a shift in ANZ portfolio composition as the lending activity of subsidiaries National Mutual Royal Bank and National
Mutual Royal Savings Bank was transferred to the
lead bank’s balance sheet.
(2) In January 1991, the share of commercial loans in
the CBA portfolio dropped, with a corresponding
increase in the share of housing loans. This change
was due to the acquisition of State Bank of
Victoria.
(3) In August 1990, NAB reclassified certain housing
loans as personal loans, generating the observed
shift in portfolio shares.
(4) In September 1990, WBC reclassified certain personal and government loans as housing and commercial loans. This reclassification resulted in an
increase in the share of commercial loans in the
WBC portfolio and a decrease in the share of personal loans.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
R E F E R E N C E S
AUSTRALIA AND NEW ZEALAND BANKING GROUP. 1992.
Annual Report.
HANCOCK, DIANA, AND JAMES WILCOX. 1998. “The ‘Credit
Crunch’ and the Availability of Credit to Small Business.”
Journal of Banking and Finance 22 (August):
983–1014.
BATTELLINO, RICK, AND NOLA MCMILLAN. 1989. “Changes
in the Behaviour of Banks and Their Implications for
Financial Aggregates.” Reserve Bank of Australia
Research Discussion Paper 8904, July.
HANCOCK, DIANA, ANDREW LAING, AND JAMES WILCOX. 1995.
“Bank Capital Shocks: Dynamic Effects on Securities,
Loans, and Capital.” Journal of Banking and Finance
19 (June): 661–77.
BERGER, ALLEN N., RICHARD HERRING, AND GIORGIO SZEGO.
1995. “The Role of Capital in Financial Institutions.”
Journal of Banking and Finance 19 (June): 393–430.
BERGER, ALLEN N., ANIL KASHYAP, AND JOSEPH SCALISE.
1995. “The Transformation of the U.S. Banking Industry:
What a Long, Strange Trip It’s Been.” Brookings Papers
on Economic Activity, no. 2:55–218.
BERGER, ALLEN N., AND GREGORY F. UDELL. 1994. “Did RiskBased Capital Allocate Bank Credit and Cause a ‘Credit
Crunch’ in the United States?” Journal of Money,
Credit, and Banking 26, no. 3 (part 2): 585–628.
BERNANKE, BEN, AND CARA LOWN. 1991. “The Credit
Crunch.” Brookings Papers on Economic Activity,
no. 2:205–47.
BLUNDELL-WIGNALL, ADRIAN, AND MARIANE GIZYCKI. 1992.
“Credit Supply and Demand and the Australian Economy.”
Reserve Bank of Australia Research Discussion Paper
9208, July.
BOYD, JOHN H., PEDRO GOMIS, SUNGKYU KWAK, AND BRUCE D.
SMITH. 2000. “A User’s Guide to Banking Crises.”
Unpublished paper.
COMMITTEE OF INQUIRY INTO THE AUSTRALIAN FINANCIAL
SYSTEM. 1981. Australian Financial System: Final
Report of the Committee of Inquiry. Canberra: AGPS.
EDEY, MALCOLM, AND BRIAN GRAY. 1996. “The Evolving
Structure of the Australian Financial System.” In The
Future of the Financial System, edited by M. Edey.
Sydney: Reserve Bank of Australia.
FISHER, CHAY, AND CHRISTOPHER KENT. 1999. “Two
Depressions, One Banking Collapse.” Reserve Bank of
Australia Research Discussion Paper 1999-06, June.
KAUFMAN, GEORGE. 1992. “Capital in Banking: Past,
Present, and Future.” Journal of Financial Services
Research 5 (April): 385–402.
LOWE, PHILIP. 1995. “The Link between the Cash Rate
and Market Interest Rates.” Reserve Bank of Australia
Research Discussion Paper 9504, May.
MACFARLANE, IAN. 1991. “The Lessons for Monetary
Policy.” In The Deregulation of Financial Intermediaries, edited by I. Macfarlane. Sydney: Reserve
Bank of Australia.
ONGENA, STEVEN, DAVID C. SMITH, AND DAG MICHALSEN.
1999. “Distressed Relationships: Lessons from the
Norwegian Banking Crisis (1988–91).” Unpublished
paper.
RESERVE BANK OF AUSTRALIA. 1992. “Bank Interest Rate
Margins.” Reserve Bank of Australia Bulletin (May): 1–6.
———. 1997. Prudential Statements.
COMMONWEALTH BANK OF AUSTRALIA. 1992. Annual Report.
CONROY, F. 1997. “Managing Credit Risk—An Overview:
Discussion.” In Credit Risk in Banking, edited by B.
Gray and C. Cassidy. Sydney: Reserve Bank of Australia.
KANG, JUN-KOO, AND RENÉ M. STULZ. 2000. “Do Banking
Shocks Affect Borrowing Firm Performance? An Analysis
of the Japanese Experience.” Journal of Business 73
(January): 1–24.
STEVENS, GLENN. 1997. “Some Observations on Low
Inflation and Household Finances.” Reserve Bank of
Australia Bulletin (October): 38–47.
THOMPSON, GRAEME. 1991. “Prudential Lessons.” In The
Deregulation of Financial Intermediaries, edited by
I. Macfarlane. Sydney: Reserve Bank of Australia.
ULLMER, MICHAEL. 1997. “Managing Credit Risk—An Overview.” In Credit Risk in Banking, edited by B. Gray and
C. Cassidy. Sydney: Reserve Bank of Australia.
WESTPAC BANKING CORPORATION. 1991. Annual Report.
GRENVILLE, STEPHEN. 1991. “The Evolution of Financial
Deregulation.” In The Deregulation of Financial
Intermediaries, edited by I. Macfarlane. Sydney:
Reserve Bank of Australia.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
33
The Potential for
Portfolio Diversification
in Financial Services
A L A N K . R E I C H E R T
L A R R Y D . W A L L
A N D
Reichert is a professor of finance at Cleveland State
University, Cleveland, Ohio. Wall is a research officer
in the financial section of the Atlanta Fed’s research
department. The authors thank Ray DeGennaro, Jerry
Hanweck, Frank King, Steve Smith, and Larry White
for helpful comments.
T
HE RECENT PASSAGE OF THE
GRAMM-LEACH-BLILEY ACT REWRITES THE RULES RELATING TO
THE AFFILIATION OF BANK AND NONBANK FINANCIAL SERVICES PROVIDERS.
PREVIOUSLY,
RULES HAD SOUGHT TO PREVENT OR AT LEAST RESTRICT COMMERCIAL BANKS’ ABILITY TO
AFFILIATE WITH INVESTMENT BANKS AND INSURANCE COMPANIES.
less effective over time as financial firms used
advances in information processing and financial
technology to avoid the rules by offering products
that were functionally equivalent to those that they
could not legally provide.1 The effectiveness of the
rules was further diminished as sympathetic regulators reinterpreted prior law to allow their regulatees
to enter other parts of the financial services industry.
Nevertheless, the old rules imposed costly restrictions on a bank’s ability to provide investment banking and insurance activities. Moreover, they often
had the effect of preventing investment banking and
insurance firms from owning a commercial bank.
The Gramm-Leach-Bliley Act removes most of the
impediments to the affiliation of commercial banks
with investment banks and insurance companies.
Although the Gramm-Leach-Bliley Act largely eliminates the barriers to affiliation within the financial
services industry, it does not necessarily follow that
financial supermarkets will come to dominate the
financial services industry, as some had predicted.
THESE RULES HAD BECOME
Any financial conglomerates that emerge must be at
least as profitable as firms that focus on specific
market segments, and the conglomerates must earn
higher risk-adjusted rates of return if they are to
dominate. Berger (forthcoming) surveys a large number of existing studies of cost and profit efficiency in
the financial services industry to assess the
prospects for such financial conglomerates. While
pointing out that the available evidence is incomplete in a number of important ways, he concludes
that the largest possible gains appear to exist from
the greater risk-diversification potential of conglomerates. Conglomerates may exploit the gains
from diversification by increasing the proportion of
their portfolio invested in higher-return assets—for
example, by holding proportionately more loans and
fewer securities—without increasing the riskiness of
the total portfolio. Thus, assessing the potential of
diversification to reduce risk is a potentially important
issue in understanding the effect of the GrammLeach-Bliley Act on financial conglomeration.2
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
35
The potential for diversification has been considered in a number of studies. Wall, Reichert, and
Mohanty (1993) survey prior studies in this area.
They also provide an analysis of the strengths and
weaknesses of alternative methodologies, which is
adapted here in the box on page 8. In addition, they
present new evidence using Internal Revenue
Service (IRS) data on industry-level return on
assets. They find an emerging consensus that pairwise combinations of individual firms provided
insignificant gains from diversification at best and
an increase in risk at worse. However, following
Litan (1985) and using IRS data over the 1974–89
period, they find gains from forming portfolios of
bank and nonbank
activities when using
IRS rather than indiAlthough the Gramm-Leachvidual bank data.
Certain portfolios of
Bliley Act largely eliminates
bank and nonbank
the barriers to affiliation
activities showed
within the financial services
substantially higher
returns for lower
industry, it does not necesrisk. However, Wall,
sarily follow that financial
Reichert, and Mohanty
supermarkets will come to
(1993) also find that
their results were
dominate the financial
time-dependent. For
services industry.
example, they find
that life insurance was
the dominant part of
the lowest-risk portfolios in the 1974–80 subperiod
whereas it was a relatively small part of those portfolios in the 1981–89 subperiod.
This article updates the contribution of Wall,
Reichert, and Mohanty (1993) in several ways. It
begins with a brief review of the literature since
1993. Next, it summarizes the legal changes resulting from the recent passage of the Gramm-LeachBliley Act. The article then extends the earlier
empirical analysis, first by updating the analysis of
the potential gains from diversification using IRS
data on return on assets through 1997 and then by
extending the diversification analysis to consider
profitability as measured by return on equity using
IRS data from 1990 to 1997. The article concludes
with some speculation about the potential impact of
recent technological changes on the benefits of
forming financial conglomerates.
Literature Review
everal recent studies have addressed the issue
of the benefits and risk associated with bank
holding company diversification. Whalen
(1999a) examines the overseas insurance activities of
S
36
U.S. bank holding companies for the period from 1987
to 1997. Since U.S. banks are required to report separately on foreign bank activities, he is able to use the
return on assets (ROA) associated with these foreign
activities as his measure of performance. Whalen finds
that mean returns in insurance activities exceeded
the returns to banking as well as the returns on other
nonbanking activities by a significant margin. On a
stand-alone basis, insurance activities appear to be
somewhat riskier than other nonbanking services, but
when combined with traditional banking activities the
combination can noticeably improve a bank’s
risk/return opportunities. Whalen concludes that
insurance activities that constitute less than 10 percent of a diversified financial firm’s total assets should
not present a major problem for regulators.
In a similar study (1999b), Whalen examines the
foreign securities activities of U.S. banks. Using
industry-level data he finds that the average security
returns are similar to the returns of traditional banking activities, while measures of risk are somewhat
higher. According to firm-level data, average security
returns exceeded banking returns by a substantial
margin, while security-related risk was higher.
However, Whalen concludes that, taking into account
the low correlation of foreign investment bank returns
with those of their U.S. bank affiliates, overseas securities activities have reduced risk for U.S. banks.
Kwan (1998) studies the relative risk and return
associated with both securities underwriting and
trading by comparing the performance of bank holding company securities affiliates called Section 20
subsidiaries with their commercial bank affiliates.
Kwan finds that those securities subsidiaries tend to
be riskier but not always more profitable. On the
other hand, the low correlation of securities and
bank returns provides some degree of diversification benefits. Kwan concludes that underwriting
activities generate likely diversification benefits for
both security trading and traditional commercial
banking activities.
Two papers expand the focus to examine combinations of banks with financial firms that are currently unaffiliated with banks. Laderman (2000)
generates synthetic banks to simulate the entry of
both large banks and all banks into eight other types
of firms. She finds that all of the activities she examined would reduce bank risk but that in some cases
the benefits would occur only at trivial levels of
investment in nonbank activities. The largest
weights were on firms involved in various aspects of
insurance and securities. Allen and Jagtiani (1999)
also generate synthetic banks to simulate the
impact of both insurance and securities activities.
They find that these nonbank activities reduce the
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
firm’s total risk but serve to increase systematic
market risk. The authors conclude that the benefits
of diversification alone are not sufficient to support
the expansion of bank power in the securities and
insurance areas.
The Gramm-Leach-Bliley Act
he changes in the Gramm-Leach-Bliley Act
may be characterized as facilitating the continued evolution of the financial system
rather than permitting revolutionary change. While
the barriers separating commercial banking from
investment banking and insurance may have at
times seemed almost impenetrable, changes in both
the markets and the regulators’ interpretations of
existing law had allowed considerable competition
across different subsectors of the financial services
industry over the last several decades.
Pre-Gramm-Leach-Bliley Act. The GlassSteagall Act adopted in 1933 prohibited commercial
banks from being affiliated with firms “engaged
principally” in investment banking activities such as
the issuing, floatation, underwriting, public sale, or
distribution of securities.3 At the same time, the act
did not completely prohibit commercial banks from
conducting all types of investment banking services.
For example, banks could underwrite municipal
general obligation bonds and offer certain investment services through their trust departments.
Banking organizations could also offer a variety of
investment banking products in foreign markets,
allowing U.S. banking organizations to develop some
experience in investment banking.4
Although commercial banks obtained explicit
authorization to provide a limited range of securities
services, the Glass-Steagall Act effectively kept
them out of the mainstream of domestic investment
banking. Investment banks had somewhat more success in offering close substitutes for traditional
T
banking products. The rapid growth of the commercial paper market has reduced large firms’ use
of short-term commercial loans from banks.
Investment banks also used money market mutual
funds to provide a substitute for demand deposits at
commercial banks.
Banks gradually expanded their investment
banking activities as the regulatory agencies reinterpreted ambiguous parts of the statutory law.5
Probably the most significant reinterpretation
relates to the Glass-Steagall Act’s prohibition on
commercial banks’ affiliation with firms that “principally engaged” in bank-ineligible activities. Bank
lawyers argued that this provision allowed banks to
be affiliated with a
securities firm as long
as the securities firm
Although commercial
was not “principally
engaged” in ineligible
banks obtained explicit
activities. 6 In 1987
authorization to provide a
the Federal Reserve
limited range of securities
Board agreed with
this interpretation. 7
services, the GlassAt first, the securities
Steagall Act effectively
subsidiaries approved
kept them out of the
by the Federal Reserve
(Section 20 submainstream of domestic
sidiaries) were subinvestment banking.
ject to strict limits on
what they could
underwrite and the
extent to which they could engage in bank-ineligible
activities. These activities were also subject to “firewalls” that limited the potential for the securities
affiliate to put the commercial bank at risk but may
have limited possible synergies between the two
types of affiliates. The various restrictions were
relaxed in subsequent years as commercial banks
and their regulators gained experience with Section
1. For example, investment banks offered money market mutual funds as a substitute for bank deposits, and banks offered syndicated loans as a substitute for underwriting bonds.
2. Whether the potential for diversification gains is in fact realized will depend in part on how the combined firms are managed
after the takeover. Hypothetical combinations, such as those formed in this article, are inadequate for addressing the question of how the new activities will be managed. The issue of how diversification works in practice is addressed by Wall (1987),
Kwan (1998), and Whalen (1999a, 1999b).
3. See Section 9.02 of Fein (1998) for a discussion of the Glass-Steagall Act.
4. See Section 12.01 of Fein (1998) for a discussion of U.S. banking organizations’ ability to engage in securities activities outside the United States.
5. See Chapter 9 of Fein (1998) for a discussion of banks’ authority to engage in securities activities in the United States. See
also Section 1.04 for a review of the key administrative rulings authorizing banks to engage in additional securities activities,
and Section 1.05 for the relevant court cases.
6. A securities activity was considered “eligible” if the banks could legally engage in the activity without being restricted by the
Glass-Steagall Act.
7. See the Federal Reserve Board’s decision on Citicorp/J.P. Morgan & Co., Inc./Bankers Trust New York Corporation in the
Federal Reserve Bulletin (1987, 473ff).
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
37
20 subsidiaries.8 The relaxation of the restrictions,
combined with changes in investment banks’ mix of
business, allowed the Federal Reserve to approve the
acquisition of Citicorp by Travelers Group, a financial
firm with a large investment banking operation.9
Bank progress in entering the insurance field has
been slower. The laws governing banking organizations restricted their ability to provide insurance
services. However, regulatory reinterpretations of
the statutes by the Office of the Comptroller of the
Currency (OCC) in the years leading up to the
Gramm-Leach-Bliley Act were opening the door to
bank sale of insurance products. A 1916 federal law
permits national banks to act as an insurance agent
in any community of
fewer than 5,000 people. The OCC interThe Gramm-Leach-Bliley
preted this stipulation
as requiring the actual
Act ends the need for
insurance activities to
commercial banks to find
be located in commuloopholes to enter investnities with a population no greater than
ment banking and insur5,000 residents but
ance and for investment
permitting marketing
banks and insurance firms
of the insurance
nationally to commuto find loopholes to enter
nities of all sizes.10
commercial banking.
Federal bank regulators also used their
authority to control
bank organizations’ entry into other types of financial
services. The Federal Reserve limited the activities
permissible to bank holding companies under authority provided by the Bank Holding Company Act of
1956 and its amendments. All three federal bank regulators—the Federal Reserve, OCC, and the Federal
Deposit Insurance Corporation—placed limits on the
activities of subsidiaries of their banks. In the years
prior to the Gramm-Leach-Bliley Act, the OCC had
undertaken an extensive review of its rules and had
determined that subsidiaries of national banks could
provide a wide variety of financial services. This interpretation was incorporated into the agency’s Part 5
rules.11 Although national banks might have provided
a wide range of heretofore impermissible activities via
subsidiaries given sufficient time, relatively few applications for new activities were approved under Part 5
prior to the Gramm-Leach-Bliley Act.
Post-Gramm-Leach-Bliley Act. The GrammLeach-Bliley Act ends the need for commercial
banks to find loopholes to enter investment banking
and insurance and for investment banks and insurance firms to find loopholes to enter commercial
banking. Amending the Bank Holding Company
38
(BHC) Act, the Gramm-Leach-Bliley Act allows
commercial banks to be affiliated with a wide range
of financial services. As a part of its effort to reduce
the barriers between financial services companies,
the act repeals the Glass-Steagall prohibitions on
the affiliation of commercial and investment banking. At the same time, however, the act added a new
barrier separating banking and commerce.
The Gramm-Leach-Bliley Act created a new type
of bank holding company, called the financial holding company, under which nonbank activities are
organized as subsidiaries of the holding company. If
a bank holding company elects to become a financial
holding company, all of its subsidiary banks and
thrifts must meet several criteria: they must be well
capitalized and well managed and must have at least
a satisfactory Community Reinvestment Act rating.12 Financial holding companies are authorized to
engage in a variety of activities, including (1) lending, trust, and other banking activities, (2) insurance activities, and (3) securities underwriting and
dealing. The Federal Reserve, with the approval of
the Secretary of the Treasury, may also expand this
list of activities to include other “financial” or “incidental” activities. The criteria for approving additional activities include clear consistency with the
purposes of the Gramm-Leach-Bliley Act; actual or
likely changes in the financial services marketplace,
including innovation in financial and information
technology; and assessment of an activity as “necessary or appropriate” to enable financial holding
companies to compete or to use technology effectively in providing financial services.
While the Gramm-Leach-Bliley Act seeks to maintain the separation of banking and commerce, the
law recognizes that investment banks, merchant
banks, and insurance companies may acquire controlling interests in companies in the ordinary
course of business. If nonbank providers were prohibited from owning merchant banks, their cost of
owning a bank would significantly increase. Thus,
the act permits financial holding companies to own
a controlling interest in any company. However, to
limit the mixing of banking and commerce, a financial holding company must acquire the interest in
the ordinary course of business and the financial
holding company must act as a passive investor.13
The Gramm-Leach-Bliley Act also allows national
banks to have a subsidiary that engages in any activity authorized directly for the bank or any financial
activity except insurance underwriting, insurance
investments, real estate investment or development, and merchant banking.14 The Secretary of the
Treasury may expand the list of permitted activities
subject to approval by the Federal Reserve Board.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
The act limits the total assets of all financial subsidiaries of a bank to 45 percent of the bank’s assets
or $50 billion, whichever is smaller.
The Gramm-Leach-Bliley Act closes a loophole in
a previous law that allowed holding companies that
owned no bank charters and only one thrift charter
to be affiliated with commercial activities.15 The act
grandfathers any holding company that owned a
thrift charter on May 4, 1999, with the restriction
that the owner of the thrift charter may not transfer
the charter to another corporation.
Empirical Analysis
he Gramm-Leach-Bliley Act has resolved the
public policy problem of what restrictions
should be placed on banking organizations’
ability to provide nonbank services. However, financial holding companies must still evaluate which services to provide, an evaluation that may depend in
part on the diversification gains. Further, supervisors will need to evaluate the safety and soundness
implications of the new combinations arising under
the financial holding company umbrella.
While several studies provide recent evidence
using firm-level data, heretofore none have reexamined industry-level data from the most comprehensive publicly available source, IRS corporate income
tax returns. An update of Wall, Reichert, and
Mohanty’s (1993) analysis of IRS data may be useful
given the many differences between data from the
1990s and the 1970s and 1980s, including (1) a different macroeconomic environment with significantly
lower inflation and somewhat higher growth in the
T
1990s, (2) continuing innovation in the financial
sector, most notably a continuation of disintermediation, and (3) changes in financial technology and in
regulatory limits, allowing financial services firms to
provide a wider range of services.16
Data. The data are obtained from the IRS
Corporate Income Tax Returns for the major sector
“Finance, Insurance, and Real Estate” (Major Group
60) for the years 1974–97. This is the same source
of the earlier data Wall, Reichert, and Mohanty used
(1993). This article follows Wall, Reichert, and
Mohanty in focusing on using ROA as the primary
measure of profitability. To facilitate comparison,
the research reproduces their results for the
1974–80 and 1981–89 periods and provides new
results for the 1990–97 period. The ROA analysis is
supplemented with an analysis of return on equity
(ROE) for the 1990–97 period.
In some years, the corporate returns publication
contains two related columns, “Net Income” and
“Deficit.” Net income refers to total net income for
corporations reporting positive earnings for the
year. Deficit refers to total losses incurred by corporations reporting losses for the year. In this study,
aggregate industry profits for the year were calculated by subtracting the deficit figure from the net
income figure to provide a comprehensive picture of
industry performance for that year. In some other
years a net profit for the total industry is provided
by the IRS. A breakdown of the industry categories
used by the IRS is provided in the appendix.
Descriptive Statistics. Table 1 presents the
results of the ROA analysis by major sector. The first
8. See Section 9.05 of Fein (1998) for a review of the original firewalls and the subsequent modifications.
9. Travelers Group applied to the Board of Governors of the Federal Reserve System to acquire Citicorp and, thereby, become
a bank holding company (which would be renamed Citigroup). The Travelers Group owned Salomon, Smith Barney Inc., one
of the largest securities firms in the United States. The Board approved the application on September 23, 1998 (Federal
Reserve Bulletin 84 [1988], 985-1016). In approving the Travelers application, the Board found that Salomon, Smith Barney’s
bank-ineligible investment banking activities fell within the 25 percent of revenue test imposed at that time on Section 20
subsidiaries (page 1006 of the Bulletin) and, thus, that the investment banking activities of Travelers were not an obstacle to
the transaction. (However, the Board did rely on certain commitments of the new Citigroup to impose certain limits on its
securities and investment banking activities.)
10. For an informative discussion of the legislative issues leading up to the Gramm-Leach-Bliley Act, see the interview with
Representative James Leach in the March 2000 issue of The Region (Vol. 14, No. 1) published by the Federal Reserve Bank
of Minneapolis.
11. See the testimony of Eugene A. Ludwig, Comptroller of the Currency, before the Subcommittee on Finance and Hazardous
Materials of the Committee on Commerce of the U.S. House of Representatives, July 17, 1997.
12. Section 103 of the Gramm-Leach-Bliley Act lays out the requirements for a bank holding company to become a financial
holding company and the range of permissible activities for a financial holding company.
13. Section 103 of the Gramm-Leach-Bliley Act.
14. Section 121 of the Gramm-Leach-Bliley Act establishes the limits on national bank provision of financial services through
affiliates.
15. Section 401 of the Gramm-Leach-Bliley Act imposes restrictions on holding companies that own only one thrift charter.
16. Disintermediation is the replacement of financing via loans funded by intermediaries with loans funded by financial markets.
Examples of disintermediation include the replacement of commercial loans by banks with commercial paper sold to financial
markets and the replacement of mortgage loans held by thrifts with mortgage-backed securities held by a variety of investors.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
39
column indicates the seven broad industry categories used by the IRS to classify the finance sector.
The second column indicates, for each industry, the
three data periods used in the analysis: (1) the
prederegulation period, 1974–80; the initial deregulation period, 1981–89; and the most recent period,
1990–97, which has witnessed continued deregulation and rapid industry consolidation. Congress
passed the Depository Institution Deregulation and
Monetary Control Act (DIDMCA) in March 1980.
DIDMCA is widely regarded as the major piece of
legislation that formally ushered in the era of financial deregulation. DIDMCA was shortly followed by
the Garn-St. Germain Act of 1982, which accelerated
the deregulation process.
The third and fourth columns give the mean
industry ROA for each period and the associated
industry rank (with larger ROAs ranked higher).
The next column indicates the degree of earnings
volatility associated with each industry, as measured
by the coefficient of variation of ROA over the given
time period for industries with positive mean
returns. The coefficient of variation of ROA is the
ratio of the standard deviation of returns over the
period to the mean return over the period.17 In the
next column, volatility is ranked from low to high
(thus, industries with low volatility are ranked
high). The remaining columns indicate the simple
correlation between the ROA of bank holding companies and each industry group. The value of the
correlations is ranked from highly positive to highly
negative. Thus, industries with high negative correlations are ranked high while industries with high
positive correlations are ranked low.
ROA is a broad measure of the efficiency with
which resources are employed within an industry
and is calculated by dividing annual net income by
total year-end assets.18 As indicated in Table 1, while
the banking sector ranked only fifth out of seven in
terms of average ROA, it experienced a threefold
increase in average earnings during the 1990–97
period compared with the two earlier periods. The
only other sector to experience such a dramatic
improvement was other credit agencies. While banking historically has recorded a relatively low degree
of earnings volatility, the sector was ranked number
one as reflected by the lowest coefficient of variation
during the decade of the 1990s. From a simple pairwise correlations perspective, the holding and other
investment companies sector had the second-lowest
TA B L E 1
Industry ROA Volatility and Correlation Analysis, 1974–97
Coefficient of
Variation of ROA
ROA
Industry
a
b
Period
Mean Value Rank
Correlation with
Bank Holding Companies
Value
Rank
Value
Rank
Bankinga
1974–80
1981–89
1990–97
.29
.24
.84
7
5
5
25.2
65.3
39.6
2
3
1
.87
.96
.99
6
7
7
Credit Agencies
(other than banks)
1974–80
1981–89
1990–97
.35
–.40
1.68
6
7
3
89.2
163.7
172.1
7
6
6
.27
.68
.32
2
6
2
Insurance (broad category )
1974–80
1981–89
1990–97
1.48
.61
1.10
4
3
4
36.6
78.6
46.9
3
5
4
.85
.66
.88
5
5
6
Insurance Agents and Brokers
1974–80
1981–89
1990–97
7.15
3.74
6.03
1
2
1
21.8
54.5
41.3
1
2
2
.76
.63
.77
4
4
4
Real Estate (broad category )
1974–80
1981–89
1990–97
1.61
.20
–.09
3
6
7
63.3
237.5
NMb
6
6
.94
–.43
.46
7
3
3
Security, Commodity
Brokers and Services
1974–80
1981–89
1990–97
1.29
.59
.83
5
4
5
52.1
69.3
47.8
5
4
5
–.23
–.70
.82
1
2
5
Holding and Other
Investment Companies
1974–80
1981–89
1990–97
4.66
6.40
2.99
2
1
2
37.6
19.2
45.8
4
1
3
.60
–.90
.34
3
1
1
Includes mutual savings banks, bank holding companies, and other (or independent) commercial banks.
Not meaningful.
Source: Wall, Reichert, and Mohanty (1993) and authors’ calculation using data from IRS corporate income tax returns
40
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
TA B L E 2
Banking Industry ROA Volatility and Correlation Analysis, 1990–97
Coefficient of
Variation of ROA
ROA
Industry a
Mean Value
Bank Holding Companies
Mutual Savings Banks
Independent Banks (not mutual savings
banks or bank holding companies)
Savings and Loans
Personal Credit Institutions
Business Credit Institutions
Other Credit Agencies
Life Insurance
Mutual Insurance
Other Insurance
Insurance Agents
Real Estate Operators and
Lessors of Buildings
Lessors of Mining and Oil Properties
Lessors of Railroad Properties
Condominium Management
and Coops
Subdividers and Developers
Other Real Estate
Security Brokers, Dealers
Commodity Brokers, Dealers
Regulated Investment Companies
Real Estate Investment Trusts
Small Business Investment Trusts
Holding and Other
Investment Companies
a
b
Correlation with
Bank Holding Companies
Rank
Value
Rank
Value
Rank
0.85
0.96
13
11
42.6
48.0
2
7
1.00
0.09
23
4
0.59
0.18
0.99
0.60
0.82
0.93
1.13
1.44
6.03
17
18
10
16
14
12
9
7
2
91.0
156.2
59.1
76.1
43.7
48.4
87.4
45.9
41.3
17
18
12
14
4
8
15
5
1
0.05
–0.24
0.61
0.66
0.54
0.91
0.40
0.80
0.77
3
2
14
16
12
21
9
20
19
–0.05
8.48
4.55
20
1
3
3
10
0.17
0.64
0.52
5
15
11
–1.16
–0.68
0.11
0.70
3.01
3.20
2.48
–0.41
23
22
19
15
5
4
6
21
NM
NM
1585.8
49.4
55.3
46.7
62.4
NM
–0.27
0.30
0.52
0.76
0.95
0.25
0.70
0.29
1
8
10
18
22
6
17
7
1.35
8
89.9
0.61
13
NMb
43.4
52.8
19
9
11
6
13
16
Detailed statistics for each nonbank industry group are available in Wall, Reichert, and Mohanty (1993).
Not meaningful.
Source: Authors’ calculation using data from IRS corporate income tax returns
degree of positive correlation and at the same time
was ranked high in terms of average ROA and low
earnings volatility during the 1990–97 period.
Table 2 presents similar information for the 1990–97
period for twenty-three industry sub-categories.
The most profitable sectors proved to be lessors of
mining and oil properties, followed by insurance
agencies and lessors of railroad properties. With an
average ROA of 0.85, bank holding companies
ranked 13. The three least-profitable sectors were
condominium and coop management, real estate
subdividers and developers, and small business
investment trusts.
In terms of earnings volatility, insurance agencies
ranked the lowest, followed closely by bank holding
companies and lessors of mining and oil properties.
At the other extreme, the three most volatile sectors proved to be “other” real estate, small business
investment trusts, and operators and lessors of
buildings. Based on pairwise correlations with bank
holding company earnings, the three sectors with
the smallest correlations are condominium and coop
management (–.27), savings and loans (–.24), and
independent banks (.05). However, these three sectors ranked in the bottom third in terms of both
earnings and volatility.
While ROA is useful for some purposes, ROE provides information that may be of special interest to
investors. For example, banking is a low-margin,
high-leverage industry. Thus, a bank with an ROA of
17. The coefficient of variation of ROA and of ROE may be thought of as a sort of inverse Sharpe ratio. The Sharpe ratio is a
measure of the return to bearing risk and is defined as the ratio of excess returns (mean returns less the risk-free rate) to
the standard deviation of returns. The primary difference between the two ratios is that the Sharpe ratio incorporates the
return to a riskless asset whereas the coefficient of variation does not.
18. Albeit ROA incorporates only on-balance sheet assets; off-balance-sheet exposures are not incorporated in the ratio.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
41
B O X
Evaluation of Prior Studies
he studies of portfolio diversification discussed in
Wall, Reichert, and Mohanty (1993) and updated
here have approached analyzing the effects on portfolios of diversification into nonbank activities in a variety
of ways.1 The methodologies used each have significant
strengths and weaknesses that it is important to understand in evaluating the current state of the literature.
T
Measurement of Portfolio Performance
Most studies of the effect of portfolio diversification
focus on one or two risk measures: the coefficient of
variation of some return measure or the risk of failure
calculated using accounting or market data. The coefficient of variation is, as noted in the text, merely the variability of returns (standard deviation of returns) divided
by the expected return. The risk of failure incorporates
a firm’s equity capital, its expected returns, and standard deviation of returns to provide a measure of the
likelihood that a firm will experience losses that exceed
its capital. Risk of failure is a more direct measure of the
primary regulatory concern: Would increased participation in nonbank activities make banks more or less likely
to fail? However, implicit in the risk-of-failure measure
is the assumption that the combined organization’s capital structure will be the sum of its individual premerger
capital structures, an assumption that may not be appropriate if regulators require higher postmerger capital
levels. Further, calculation of the risk of failure requires
data on premerger capital structures that may not be
available from some data sources.
A further consideration in evaluating portfolio performance is the perspective of bank owners and managers. Most studies focus on risk issues because that is
the regulator’s concern. Bank owners and managers,
however, actually undertake mergers on the basis of
the effect of diversification on both the return and risk
of the combined organization. Banks may engage in a
risk-reducing merger if the reduction in their expected
return is not too large, but they may also be willing to
undertake higher risk if the increase in expected
return is sufficiently large.2 Thus, a full analysis of the
effect of diversification on returns must consider both
the banks’ and the regulators’ perspectives.3
Formation of Portfolios
The various studies of bank mergers take three different approaches to forming the portfolios for analysis.
Some studies limit their analysis to three or four statistics: industry-average mean returns, industry-average
standard deviations of returns, industry-average
coefficients of variation of returns on assets, and the
correlation of industry returns with banking returns.
Looking at industry statistics alone does not allow an
42
easy determination of the change in risk that results
from combining different industries into a single
firm. For example, an industry might have a higher
standard deviation of returns than banking, but the
returns may be negatively correlated with banks’
returns. Thus, it is not always clear whether the higher
standard deviation of a particular firm from this
industry combined with a banking firm will increase
the risk to the postmerger organization or whether
its negative correlation with banking will generate
less risk.
An alternative to using overall industry statistics is to
combine industries in pairs—banks and one nonbank
industry at a time. This approach provides for simultaneously considering the effects of expected return, the
standard deviation of returns, and the correlation
between returns (as well as the capital positions of the
two firms, when appropriate). Perhaps most importantly, this approach has the advantage of corresponding with actual bank behavior. Because firms typically
engage in one merger at a time, the concern to banks
and their regulators at any given point in time is the
desirability of a particular pairwise combination.
The third alternative in examining portfolios is to
analyze efficient portfolios of banks and several nonbank industries. As discussed in the article, the term
“efficient portfolio” refers to one whose combinations
produce the most return for any given level of return
variability (or, equivalently, the least return variability
for any given return). These portfolios may contain
firms operating in only two industries (or in some
cases a single industry). However, as Litan (1985)
found, some efficient portfolios are likely to contain
multiple industries. Examining portfolios of unique
service products is advantageous because it is the
approach that banks should take from a portfolio risk
and return perspective. Thus, basing public policy
solely on the risk effects of pairwise mergers may
impose significant social costs if it results in policies
that prevent the formation of efficient portfolios of
bank and nonbank firms.
Timing of Aggregation to Industry Level
The various studies take two approaches to the
aggregation of firm data into industry statistics. Some
studies combine individual firms into a single industry
before conducting any analysis, and others calculate
the mean and variability of returns for individual firms
(and across pairs of firms) and then aggregate the figures across all firms in the industry (or in the pair of
industries). The major disadvantage of the first
approach is that individual firms enter into mergers
with specific firms, not with broad industries. On the
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
other hand, industry aggregate figures may be a better
proxy for the expected future distribution of returns to
the extent that two conditions hold—that is, if withinindustry differences primarily arise from regional economic conditions and if firms within industries are
combining across regions. Another advantage of using
industry aggregates is that spurious results in the formation of portfolios may be less likely.
An efficient portfolio is formed by looking at an
individual entity’s “assets” to determine the combinations that produce an efficient set of portfolios. These
assets may be defined as entire industries or as individual firms within industries. Obviously, the number
of separate assets for inclusion in an efficient portfolio will increase dramatically if individual firm returns
are used rather than industry returns. In general, an
increase in the number of assets is likely to increase
the chances of identifying lower-risk portfolios. Thus,
Boyd, Graham, and Hewitt (1993) argue that random
chance favors the possibility that a risk-reducing
portfolio will be found using individual firm data even
if there is not a real opportunity for diversification to
reduce risk.
Use of Market or Accounting Data
Banks’ and nonbank firms’ returns may be measured
using accounting or financial market data. The drawback to using accounting data is that they are not perfectly correlated with economic returns. Firms often try
to smooth accounting data through time, producing
reported returns that are deliberately low in the good
years and high in the bad years. If firms across different
industries have unequal ability to smooth their accounting earnings, then accounting-based risk measures may
not provide accurate interindustry comparisons of risk.
Using accounting data has some appeal, however. First,
market data is typically available only for the largest
firms in an industry, so it clearly is more limited than
accounting data. In addition, regulators rely heavily on
accounting figures in their evaluation of a bank’s financial condition.
Studies that rely on accounting data use two sources
of information: accounting data from the individual
firm’s public financial statements prepared according
to generally accepted accounting principles (GAAP)
and accounting data published by the IRS for all firms
in an industry prepared according to IRS accounting
rules. Each data set has its advantages. GAAP rules are
intended to fairly present a firm’s performance over
time whereas IRS rules also reflect a number of public
policy decisions. For example, to encourage banks to
hold state and local government obligations, IRS rules
allowed banks to understate their income by excluding
the interest from holding these obligations. Another
advantage of using GAAP data is that they are available
at the individual firm level, and IRS data are available
only for an entire industry. On the other hand, IRS data
reflect a broad cross-section of firms in an industry
while public financial statements are only available for
the largest firms.
Overall Evaluation of Prior Studies
As the above discussion suggests, there appears to
be no single “correct” methodology. Each has advantages and disadvantages. Ideally, the different
approaches would produce consistent results confirming that individual findings were not the result of a
unique methodology.
1. This box is adapted from Wall, Reichart, and Mohanty (1993).
2. See Boyd and Graham (1986) for a discussion of the issue of managerial incentives.
3. Boyd, Graham, and Hewitt (1993) point out that an important issue in evaluating the effect of a merger is the purchase price
paid for the target by the acquiring organization. Virtually all studies of historical data implicitly assume that no premium will
be paid to the target. Researchers use this assumption not because it is realistic but because they have no good basis for
determining the likely magnitude of the takeover premium.
only 1.25 percent and a capital-to-asset ratio of 8
percent, would earn a 15.6 percent ROE. On the
other hand, a brokerage firm with an ROA of 5 percent and a capital-asset ratio of 50 percent, would
earn only a 10 percent ROE. Table 3 replicates Table 2
using ROE over the 1990–97 period.
The use of ROE rather than ROA improved the
profitability rankings of depositories (bank holding
companies, mutual savings banks, independent
banks, and savings and loans), as would be expected
from their generally low capital-to-asset ratios. The
lower capital ratios also boosted the standard deviation of returns. The net result of the increase in the
profitability ratio and the standard deviation for bank
holding companies is small; they had the second lowest coefficient of variation using ROA and the lowest
coefficient of variation using ROE. The use of ROE
rather than ROA caused some changes in the rankings by correlation with bank holding companies, but
the differences are generally small.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
43
Efficient Portfolios Using Return on Assets.
Table 4 forms efficient portfolios of selected sectors
that provide both traditional banking-related services, such as mutual savings banks, savings and
loans, and personal and business credit companies
and those that provide nontraditional financial services, such as security and commodity brokers and
dealers, life insurance underwriters, and security
and insurance agents and brokers.19 The portfolios
are formed subject to the assumption that investment in any given industry cannot be less than zero
and that there is no risk-free asset.
Efficient portfolio combinations of activities that
have traditionally been closely related to banking
are presented in the top part of Table 4. The portfolio
calculation program calculates the efficient frontier
and provides detailed information on portfolios at
points selected by the user. 20 In order to provide an
overview of the results, portfolios are obtained at
various levels of return. Given that the program
rounds returns and variances, the point selected to
obtain a portfolio for each level of return is the one
with the lowest standard deviation of return. Thus,
portfolio B for the 1990–97 period was selected to
have an ROA of 0.7 percent. The lowest standard
deviation of return for a portfolio with an ROA of 0.7
percent is 0.2 percent. The resulting coefficient of
variation is 28.6 percent. A portfolio that yields
these returns would invest the following percentages in each industry: 31.0 percent in mutual savings
banks, 28.1 percent in bank holding companies, 33.9
percent in savings and loan associations, 4.3 percent
in personal credit companies, and 2.7 percent in
business credit companies.
Evaluating the results requires a rough standard
for judging the extent to which bank holding companies should be allowed to diversify. One reasonable
standard suggests that bank holding companies
should be allowed to diversify as long as the nonbank
activity does not increase the coefficient of variation
above that of bank holding companies by themselves. For 1974–80, the mean ROA is 0.27 and the
coefficient of variation is 30.6; for 1981–89 the mean
ROA is 0.26 and the coefficient of variation is 34.4.
TA B L E 3
Banking Industry ROE Volatility and Correlation Analysis, 1990–97
Coefficient of
Variation of ROE
ROE
Industry
Mean Value
Bank Holding Companies
Mutual Savings Banks
Independent Banks (not mutual savings
banks or bank holding companies)
Savings and Loans
Personal Credit Institutions
Business Credit Institutions
Other Credit Agencies
Life Insurance
Mutual Insurance
Other Insurance
Insurance Agents
Real Estate Operators and
Lessors of Buildings
Lessors of Mining and Oil Properties
Lessors of Railroad Properties
Condominium Management
and Coops
Subdividers and Developers
Other Real Estate
Security Brokers, Dealers
Commodity Brokers, Dealers
Regulated Investment Companies
Real Estate Investment Trusts
Small Business Investment Trusts
Holding and Other
Investment Companies
a
Rank
Value
Rank
Value
Rank
8.2
13.4
8
5
38.4
44.3
1
4
1.00
0.06
23
4
8.1
7.5
5.6
8.1
10.5
7.3
4.2
4.5
16.4
9
11
13
10
7
12
16
14
3
99.7
184.5
47.1
52.0
42.5
47.8
85.2
43.6
61.8
17
18
6
10
2
7
16
3
13
0.06
–0.39
0.85
0.64
0.63
0.83
0.40
0.65
0.48
5
1
21
17
16
20
11
18
14
–0.4
19.1
10.6
19
1
6
NMa
62.8
53.7
NM
14
12
0.06
0.25
0.46
3
7
13
–2.3
–4.5
–0.9
15.9
18.1
3.3
4.4
–1.2
22
23
20
4
2
17
15
21
NM
NM
NM
51.0
52.6
46.7
47.8
NM
NM
NM
NM
9
11
5
8
NM
–0.31
0.30
0.34
0.79
0.91
0.25
0.52
0.16
2
9
10
19
22
8
15
6
3.3
18
81.0
15
0.41
12
Not meaningful.
Source: Authors’ calculation using data from IRS corporate income tax returns
44
Correlation with
Bank Holding Companies
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
Traditional Banking Activities. Looking at traditional banking activities in Table 4 and applying the
above standard to the 1974–80 period, portfolio D, a
financial services holding company comprising mutual
savings banks (37.5 percent), personal credit (15.5
percent) and business credit (47 percent) institutions,
and less than 1 percent savings and loans and bank
holding companies would have generated an ROA
approximately three times as large as reported by bank
holding companies alone, with roughly the same level
of risk (coefficient of variation of 25.0 percent vs. 30.6
percent). During the middle period (1981–89), financial institutions with approximately the same degree of
risk as bank holding companies, portfolio A, would
have allocated more than 93 percent of their assets to
mutual savings banks, with the remaining assets
invested in personal credit institutions.
In contrast to the earlier periods, bank holding companies are included in all of the portfolios over the
1990–97 period in proportions that range from approximately 10 percent to 33 percent. All of the portfolios
have a coefficient of variation less than bank holding
companies by themselves. Mutual savings banks
remain a substantial part of all portfolios and dominate
the highest-return portfolio. Savings and loan companies also enter the lower-return efficient portfolios and
provide more than one-half of the assets in the lowestrisk portfolio. Personal credit and business credit institutions also enter all but the highest-return portfolio,
but these activities generally receive less weight than
in prior periods. The variance of returns and the coefficient of variation of returns in the last period are
greater than those during the 1974–80 period but less
than those of the 1981–89 period.
Nontraditional Banking Activities. In terms of
nontraditional activities, Table 4 presents a much
wider range of possible ROAs, reflecting the greater
earnings opportunities available outside traditional
banking services. For the two earlier periods, bank
holding companies play a significant role but only for
portfolios A and B, which yield relatively low ROAs
(1.0–1.5 percent). Table 4 indicates that, even at low
levels of return, during the 1970s a dramatic increase
in ROA could be achieved by diversifying into a variety of nontraditional activities while at the same time
reducing risk by approximately 50–60 percent. For
example, in portfolio B a financial services company
that invests only 14 percent of its assets in bank
holding companies and the majority of its assets (70
percent) in life insurance would generate a coefficient of variation of only 6.7 percent and an expected ROA of 1.5 percent, compared with a pure bank
holding company that reported a coefficient of variation of 30.6 percent and an average ROA of 0.27
percent during the same period. Of the remaining
financial sectors, either life insurance underwriting
or insurance agents and brokers dominate the portfolio for higher expected returns. For the 1980s, an
optimal portfolio mix suggests that bank holding
company involvement disappears entirely beyond
an expected ROA of
2.5 percent and a
coefficient of variaAs financial holding comtion of 7.2 percent.
panies become more diverThese figures compare
sified, it will become more
quite favorably to an
ROA of only 0.26 perdifficult to measure the
cent and a coefficient
benefits of diversification
of variation of 34.4
by simply forming efficient
percent for bank holding companies alone
portfolios. Diversification
during this period.
will take place as much
During the 1990s the
within as between industry
picture changes quite
dramatically, with bank
classifications.
holding companies
contributing meaningfully in virtually all portfolios with an ROA of 4.5 percent or less (portfolios A–G). The remainder of the
efficient portfolios including nontraditional activities
consists largely of insurance agents and regulated
investment companies. The only exception is the lowest-return portfolio, in which security brokers are
approximately one-fifth of the portfolio. Commodity
brokers, life insurance underwriters, and subdividers
and developers do not enter the efficient portfolio (no
greater than 0.1 percent) except for a small share (1.4
percent) devoted to subdividers and developers in
portfolio I. The standard deviation of ROA and the
coefficient of variation of ROA are higher during the
last period than either of the preceding two periods.
However, the coefficient of variation of ROA is not
19. The mathematics of linear algebra limits the number of industries to no more than the number of years in a sample. If the
optimization program is given more industries than years then one or more industries will become linear combinations of
the other industries and the solution to each of the efficient portfolios will not be unique. The table illustrates the optimal
combination of each industry for selected ROAs.
20. The program used to form the portfolios is The Investment Portfolio, version 1.0, designed by Edwin J. Elton, Martin J. Gruber,
and Christopher R. Blake. The program sometimes had problems forming efficient portfolios when the portfolio share of an
industry was allowed to vary between 0 percent and 100 percent. However, in these cases it was able to estimate the efficient
portfolio when each asset was constrained to consist of no more than 99.99 percent of the portfolio.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
45
TA B L E 4
Efficient Portfolios of Both Traditional and Nontraditional Financial Services, ROA (Percent)a
Traditional Activities
1974–80
A
B
C
D
Efficient Risk and Return Combination
Mean ROA
Standard Deviation ROA
Coefficient of Variation
0.5
0.1
26.0
0.7
0.2
24.3
0.9
0.2
24.4
1.0
.2
25.0
Associated Portfolio Allocations
Mutual Savings Banks
Bank Holding Companies
Savings and Loan Associations
Personal Credit Institutions
Business Credit
80.2
0.0
0.0
5.5
14.3
63.1
0.0
0.0
9.5
27.4
46.0
0.0
0.0
13.5
40.5
37.5
0.5
0.5
15.5
47.0
A
B
C
D
Efficient Risk and Return Combination
Mean ROA
Standard Deviation ROA
Coefficient of Variation
0.3
0.1
40.0
0.4
0.3
62.5
0.6
0.5
90.0
0.8
0.8
103.8
Associated Portfolio Allocations
Mutual Savings Banks
Bank Holding Companies
Savings and Loan
Personal Credit
Business Credit
93.1
0.0
0.0
6.9
0.0
75.9
0.0
0.0
24.1
0.0
41.4
0.0
0.0
58.6
0.0
6.9
0.0
0.0
93.1
0.0
1981–89
1990–97
A
B
C
D
Efficient Risk and Return Combination
Mean ROA
Standard Deviation ROA
Coefficient of Variation
0.5
0.1
20.0
0.7
0.2
28.6
0.9
0.3
33.3
1.0
0.4
40.0
Associated Portfolio Allocations
Mutual Savings Banks
Bank Holding Companies
Savings and Loan
Personal Credit
Business Credit
25.2
10.0
52.4
0.0
12.4
31.0
28.1
33.9
4.3
2.7
39.9
33.4
6.6
20.1
0.0
86.0
14.0
0.0
0.0
0.0
substantially greater and is generally slightly less for
each of the portfolios of nontraditional activities than
for bank holding companies by themselves.
The benefits for diversification into nontraditional
financial activities during the two earlier periods were
two-dimensional in that the bank holding company
could achieve a significant increase in expected earnings while achieving a substantial reduction in risk. On
the other hand, the benefits for diversification during
the past decade had little to do with risk reduction but
appear to have been related almost entirely to a substantial increase in expected earnings.
Efficient Portfolios Using Return on Equity.
The ratio of equity capital to assets varies across different types of financial services providers.21 Thus,
the efficient portfolio allocations using ROE as the
measure of profitability may be different from those
using ROA. Further, the allocations based on ROE
may provide more insight to managers of financial
firms, given that theory suggests that firms should
46
focus on maximizing shareholder wealth rather than
return on assets. Thus, Table 5 provides efficient portfolio allocations using ROE for the 1990–97 period.
The allocations for traditional activities using ROE
in Table 5 appear roughly the same as the allocations
using ROA in Table 4. The allocations are not exactly
comparable because a 10 percent allocation in Table
4 indicates that 10 percent of assets should be invested
in the industry whereas the same percentage allocation in Table 5 indicates that 10 percent of equity
should be invested in the industry. Bank holding companies constitute a large fraction of the optimal portfolios with intermediate levels of ROE but are not
included in either the very low or very high return
portfolios. In contrast, mutual savings banks and savings and loans are in all of the efficient portfolios,
with mutual savings banks dominating the highreturn portfolios. All of the portfolios of traditional
activities had a lower coefficient of variation of ROE
than bank holding companies have by themselves, a
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
TA B L E 4 ( C o n t i n u e d )
Nontraditional Activities
1974–80
A
Efficient Risk and Return Combination
Mean ROA
1.0
Standard Deviation ROA
0.1
Coefficient of Variation
10.0
Associated Portfolio Allocations
Bank Holding Companies
Security Brokers
Commodity Brokers, Dealers
Life Insurance Underwriters
Insurance Agents, Brokers
Regulated Investment Companies
Subdividers and Developers
1981–89
Efficient Risk and Return Combination
Mean ROA
Standard Deviation ROA
Coefficient of Variation
Associated Portfolio Allocations
Bank Holding Companies
Security Brokers
Commodity Brokers, Dealers
Life Insurance Underwriters
Insurance Agents, Brokers
Regulated Investment Companies
Subdividers and Developers
1990–97
a
46.2
6.8
2.9
43.2
0.0
0.0
0.0
B
C
D
E
F
G
H
I
1.5
0.1
6.7
2.5
0.2
10.0
3.0
0.4
12.0
3.5
0.5
13.7
4.0
0.6
14.8
4.5
0.7
15.8
5.0
0.8
16.6
6.0
1.1
17.8
13.6
9.7
3.4
70.4
0.0
2.9
0.0
0.0
7.2
6.5
68.0
9.9
8.4
0.0
0.0
6.1
8.4
58.1
17.1
10.2
0.0
0.0
5.0
10.4
48.1
24.3
12.1
0.0
0.0
3.9
12.3
38.3
31.5
13.9
0.0
0.0
2.8
14.2
28.4
38.7
15.7
0.0
0.0
1.7
16.2
18.6
45.9
17.6
0.0
0.0
0.0
18.1
0.0
60.7
21.2
0.0
A
B
C
D
E
F
G
H
I
1.0
0.1
5.0
1.5
0.1
6.0
2.5
0.2
7.2
3.0
0.2
7.0
3.5
0.3
8.9
4.0
0.4
10.0
4.5
0.5
11.1
5.0
0.6
12.2
6.0
0.9
14.7
76.6
0.0
1.0
6.4
1.3
9.3
5.3
54.3
0.0
1.7
13.6
3.5
15.1
11.8
9.5
0.0
3.1
28.1
7.8
26.6
24.9
0.0
0.0
6.7
26.6
11.2
31.0
24.4
0.0
0.0
12.4
18.6
15.6
34.5
18.8
0.0
0.0
18.7
10.6
19.9
38.2
13.2
0.0
0.0
23.9
2.7
24.3
41.6
7.6
0.0
0.0
26.0
0.0
28.5
45.5
0.0
0.0
0.0
6.2
0.0
32.6
61.2
0.0
C
D
E
F
H
I
A
B
G
Efficient Risk and Return Combination
Mean ROA
1.0
Standard Deviation ROA
0.4
Coefficient of Variation
40.0
1.5
0.5
33.3
2.5
0.9
36.0
3.0
1.1
36.7
3.5
1.1
31.4
4.0
1.5
37.5
4.5
1.7
37.8
5.0
1.9
38.0
6.0
2.3
38.3
Associated Portfolio Allocations
Bank Holding Companies
Security Brokers
Commodity Brokers, Dealers
Life Insurance Underwriters
Insurance Agents, Brokers
Regulated Investment Companies
Subdividers and Developers
76.1
0.0
0.0
0.0
1.8
22.1
0.0
55.4
0.0
0.0
0.0
19.7
24.9
0.0
45.0
0.0
0.0
0.0
28.8
26.3
0.0
34.4
0.0
0.0
0.0
38.0
27.7
0.0
24.3
0.0
0.0
0.0
46.6
29.0
0.0
13.8
0.0
0.0
0.0
55.8
30.5
0.0
2.9
0.0
0.0
0.0
65.2
31.9
0.0
0.0
0.0
0.0
0.0
98.6
0.0
1.4
69.4
22.6
0.0
0.0
0.0
7.9
0.0
The results are rounded to one decimal place. As a result, the portfolio allocations sometimes sum to slightly more or less than 1.0.
Further, the rounding was applied independently to the mean, standard deviation, and coefficient of variation for ROA for the results
obtained from Wall, Reichert, and Mohanty (1993). Thus, the coefficient of variation for 1974–80 and 1981–89 is not necessarily equal
to the reported standard deviation divided by the mean.
Source: Wall, Reichert, and Mohanty (1993) and authors’ calculation using data from IRS corporate income tax returns
result that mirrors the finding for the coefficient of
variation of ROA for traditional activities.
The results forming portfolios using ROE for the
nontraditional activities, also seen in Table 5, can be
usefully compared with the portfolios formed using
ROA. There are several similarities: bank holding
companies enter into all of the portfolios except the
highest-risk portfolio, insurance agents enter the
higher-return portfolios, and regulated investment
companies are in the lowest-risk portfolios. Another
similarity is that life insurance does not enter any of
the portfolios for the 1990–97 period. There are also
several differences: security brokers enter the highreturn portfolios using ROE rather than the lowreturn portfolios using ROA, and commodity brokers
and dealers dominate the highest-return portfolios
21. Some finance theories hold that the ratio of equity to assets should vary across industries depending upon factors such as the
volatility of the industry’s earnings and the costs incurred by the firm if it becomes financially distressed.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
47
TA B L E 5
Efficient Portfolios of Both Traditional and Nontraditional Financial Services, ROE 1990–97 (Percent)a
Traditional Activities
A
B
C
D
E
F
Efficient Risk and Return Combination
Mean ROE
Standard Deviation ROE
Coefficient of Variation
8.0
1.7
21.3
9.0
1.8
20.0
10.0
1.8
18.0
11.0
2.4
21.8
12.0
3.3
27.5
13.0
4.6
35.4
Associated Portfolio Allocations
Mutual Savings Banks
Bank Holding Companies
Savings and Loan Companies
Personal Credit Companies
Business Credit Companies
28.9
0.0
8.2
62.8
0.0
29.3
34.0
12.0
24.7
0.0
35.6
49.5
14.9
0.0
0.0
54.9
28.3
16.3
0.0
0.5
74.3
0.0
16.8
0.0
8.9
91.9
0.0
8.1
0.0
0.0
Nontraditional Activities
A
a
B
C
D
E
F
G
H
I
Efficient Risk and Return Combination
Mean ROE
Standard Deviation ROE
Coefficient of Variation
3.0
1.2
40.0
5.0
1.5
30.0
7.0
2.3
32.9
9.0
3.2
35.5
11.0
4.2
38.2
13.0
5.3
40.7
15.0
6.4
42.7
17.0
7.6
44.7
18.0
8.5
47.2
Associated Portfolio Allocations
Bank Holding Companies
Security Brokers
Commodity Brokers/Dealers
Life Insurance Underwriters
Insurance Agents, Brokers
Regulated Investment Companies
Subdividers and Developers
7.6
0.0
0.0
0.0
0.0
83.9
8.5
33.8
0.0
0.0
0.0
0.0
66.2
0.0
65.7
0.0
0.0
0.0
3.4
31.0
0.0
88.6
0.0
0.0
0.0
10.2
1.2
0.0
67.7
6.4
10.6
0.0
15.3
0.0
0.0
45.9
10.3
24.2
0.0
19.6
0.0
0.0
24.6
14.1
37.5
0.0
23.8
0.0
0.0
2.6
18.0
51.3
0.0
28.2
0.0
0.0
0.0
0.0
89.8
0.0
10.1
0.0
0.0
The results are rounded to one decimal place. As a result, the portfolio allocations sometimes sum to slightly more or less than 1.0.
Source: Authors’ calculation using data from IRS corporate income tax returns
using ROE whereas the industry never enters the
efficient portfolio using ROA. Another difference is
that several of the portfolios formed using ROE have
lower coefficients of variation than bank holding
companies by themselves. Nevertheless, portfolios
with ROEs as high as 11 percent may be formed
from nontraditional activities, which have a lower
coefficient of variation of ROE than bank holding
companies by themselves.
Implications of the Empirical Results.
Consistent with Wall, Reichert, and Mohanty’s
(1993) findings, the above results suggest that the
optimal portfolio is time-varying.22 One new finding
is that bank holding companies are a more important element of the efficient portfolio for both traditional and nontraditional activities in the 1990s than
they were in the 1970s and the 1980s. Although the
empirical analysis is not designed to explain why
banks were more important in the 1990s, two plausible hypotheses are that banks have benefited more
from the stable macroeconomic environment in the
1990s and that banks may have benefited from
relaxed restrictions on their ability to expand geographically and into new product areas.
48
One limitation of the results is that they may imply
portfolio combinations that are not feasible, at least
for large financial holding companies. For example, the
analysis of efficient portfolios suggests that the highestreturn portfolio using ROE invests 90 percent of its
equity in commodity brokers and dealers while the
highest-return portfolio using ROA over the 1990–97
period invests almost 99 percent of its assets in insurance agents and brokers. While commodity brokers
and dealers and insurance agents were especially profitable parts of the financial services industry, they
were, in terms of assets, a relatively small portion.
Conclusion
he Gramm-Leach-Bliley Act sweeps away
most of the barriers limiting the affiliation of
banks with nonbank financial services
providers. The focus now shifts to financial services
executives who must decide which combinations
provide the best opportunities to increase shareholder wealth. Existing empirical evidence suggests
that an important consideration in this decision is
the potential gain from portfolio diversification into
new activities. The available empirical evidence also
T
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
suggests that the potential for such gain clearly
exists. However, the results provided by this article
emphasize that the efficient combination may
change over time, perhaps for reasons such as the
macroeconomic environment or technology. One
positive result from the analysis for bankers is that
in recent years banks have become a larger part of
the efficient financial services portfolio than they
were in the 1970s or the 1980s.
As financial holding companies become more
diversified, it will become more difficult to measure
the benefits of diversification by simply forming efficient portfolios. Aggregate measures of industry
profitability, such as those provided by the IRS, will
mask any synergies already present in the performance data. That is, diversification will take place as
much within as between industry classifications. On
the other hand, the IRS and other data sources may
define a new category to capture the performance of
diversified financial holding companies.
Another trend that is currently unfolding is the
trend toward using the Internet for the production
and delivery of financial services. In a review of the
Gramm-Leach-Bliley Act, Barth, Brumbaugh, and
Wilcox (2000) discuss the future of banking and
how passage of the act may allow banks to recapture
some of their lost market share. They raise the issue
as to whether the “portfolio model” as evidenced by
Citigroup, which combines in a single institution a
wide range of banking, insurance, and investment
services, will be competitive in a world of “financial
portals” like Yahoo Finance. In a recent study
Morgan Stanley Dean Witter (1999) discusses how
financial services will possibly evolve on the Internet
over the next several years. They project that financial services on the Internet will grow at an annual
compound rate of growth of 34 percent from 1999 to
2003. Annual revenue from a wide range of financial
services such as banking, brokerage services, auto
insurance, and term life insurance, as well as credit
card fees, is expected to grow from approximately
$100 billion in 1999 to $435 billion by 2003. In terms
of broad trends, Morgan Stanley Dean Witter forecasts increased competitive pressures as technological and regulatory impediments fall and as product
unbundling and price transparency put a squeeze on
profit margins. Their evaluation of various financial
models predicts that “vertical portals” will become
the ultimate distributor of financial services.
Morgan Stanley Dean Witter (1999) defines a
financial services vertical portal as a web site devoted
to financial services where cyber customers can buy
or get information on a wide variety of financial
products. Its competitive strength relates to its
breadth of product offerings, user friendliness,
twenty-four-hour, seven-days-a-week availability,
and the ability to customize. At a minimum, a financial vertical portal should allow the user to get current financial information; obtain brokerage
services; review account balances; see and pay bills;
plan for retirement; purchase life, auto, and home
insurance; and obtain a mortgage or a credit card.
In practice, financial firms appear to be trying a variety of strategies. Some firms with large investments in
brick and mortar are creating or participating in portals (for example, see Power 2000). In contrast, one
provider of financial services over the Internet,
E*Trade, has acquired a commercial bank, formerly
called Telebank, to provide a wider variety of services.
Thus, the Internet may reduce the potential synergistic gains from financial companies owning the
providers of a variety of financial services. If so, the
impact of the Internet will be to reinforce Berger’s
(2000) finding that the largest potential benefits of
conglomeration lie in reduced financial risk due to
portfolio diversification. The findings presented in
this article suggest that such portfolio diversification may allow financial firms to earn higher rates of
return at little or no increase in risk. However, the
results also suggest that the efficient combination of
services from a portfolio diversification perspective
varies through time.
22. That the optimal portfolios vary through time does not suggest that the government should restrict possible combinations.
Firms will restructure (selling some activities and buying others) if the gains from restructuring the firm’s activities are
sufficiently large.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
49
A P P E N D I X
IRS Industry Categories
he IRS corporate returns publication breaks the
general finance, insurance, and real estate sector
down into twenty-three minor industry groups as follows (a brief description for some of the less obvious
industries is included).
T
Banking
• Mutual savings banks
• Bank holding companies, including both one bank
and multibank holding companies
• Independent banks, excluding mutual savings banks
and bank holding companies
Credit Agencies
• Savings and loan associations
• Personal credit institutions, which are establishments
primarily engaged in providing loans to individuals
and establishments engaged in financing retail sales
made on the installment plan and automobile financing
• Business credit institutions, which are establishments
engaged in making loans to business and agricultural
enterprises, such as short-term business credit institutions (commercial finance companies), accounts
receivable and commercial paper factoring, direct
financing of working capital, captive automobile
finance companies (for example, GMAC), mercantile
financing, and so forth.
Real Estate
• Real estate operators and lessors of buildings, including
firms that operate and lease but do not develop real
property, such as operators of commercial and office
buildings, retail establishments and shopping centers,
and so forth
• Lessors of mining, oil, and similar properties
• Lessors of railroad property, including firms such as
airport leasing offices, landholding offices, and others
• Condominium management and cooperative housing
associations
• Subdividers and developers, including firms engaged
in subdividing real property into lots and in developing
them for resale on their own account
Security, Commodity Brokers and Services
• Security brokers, dealers, and flotation companies,
including establishments engaged in the purchase,
sale, and brokerage of securities and those, generally
known as investment bankers, that originate, underwrite, and distribute securities issues
• Commodity contract brokers and dealers; security
and commodity exchanges; and allied services, firms
that buy and sell commodity contracts on either the
spot or future basis for their own account or the
account of others and that provide investment advice
regarding securities to companies and individuals on a
contractual or fee basis, and so forth
Insurance
• Life insurance companies
• Mutual insurance companies (except life or marine
and certain fire or flood insurance companies)
Insurance Agents and Brokers
• Agents and brokers dealing in insurance
• Organizations offering services to insurance companies
and policyholders, such as insurance claim adjusters
Holding and Other Investment Companies1
• Regulated investment trusts, including a wide range
of firms such as open and closed-end investment
funds, money market mutual funds, unit investment
trusts, and so forth
• Real estate investment trusts (REITs), including
firms engaged in closed-end real estate investments
or related mortgage assets that meet the requirements of the amended Real Estate Investment Act of
1960, such as mortgage investment trusts, mortgage
and realty trusts, and real estate investment trusts
• Small business investment trusts (SBITs)
1. Excludes bank holding companies.
50
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
REFERENCES
ALLEN, LINDA, AND JULAPA JAGTIANI. 1999. “The Impact of
New Bank Powers (Securities and Insurance Activities) on
Bank Holding Companies’ Risks.” Federal Reserve Bank of
Chicago Emerging Issues Series Paper S&R-99-1E,
September.
BARTH, JAMES R., DAN BRUMBAUGH JR., AND JAMES A.WILCOX.
2000. “The Repeal of Glass-Steagall and the Advent of
Broad Banking.” Office of the Comptroller of the
Currency Economic and Policy Analysis Working Paper
2000-5, April.
BERGER, ALLEN N. Forthcoming. “The Integration of the
Financial Services Industry: Where Are the Efficiencies?”
North American Actuarial Journal.
BOYD, JOHN H., AND STANLEY L. GRAHAM. 1986. “Risk,
Regulation, and Bank Holding Company Expansion into
Nonbanking.” Federal Reserve Bank of Minneapolis
Quarterly Review 10 (Spring): 2–17.
BOYD, JOHN H., STANLEY L. GRAHAM, AND R. SHAWN HEWITT.
1993. “Bank Holding Company Mergers with Nonbank
Financial Firms: Effects on the Risk of Failure.” Journal
of Banking and Finance 17 (February): 43–63.
FEIN, MELANIE L. 1997. Securities Activities of Banks.
2d ed. New York: Aspen Publishers, Inc.
KWAN, SIMON. 1998. “The Securities Activities by Commercial Banking Firms’ Section 20 Subsidiaries: Risk,
Return, and Diversification Benefits.” Federal Reserve
Bank of San Francisco Working Paper 98-10, May.
LITAN, ROBERT E. 1985. “Evaluating and Controlling the
Risks of Financial Product Deregulation.” Yale Journal
on Regulation 3 (Fall): 1–52.
MORGAN STANLEY DEAN WITTER EQUITY RESEARCH. 1999.
The Internet and Financial Services Report:
Financial$ervices.com. New York: Morgan Stanley
Dean Witter.
POWER, CAROL. 2000. “Citi Advances in Online Payments,
Aggregation.” American Banker 165, July 19, 1.
WALL, LARRY D. 1987. “Has Bank Holding Companies’
Diversification Affected Their Risk of Failure?” Journal
of Economics and Business 39 (November): 313–26.
WALL, LARRY D., ALAN K. REICHERT, AND SUNIL MOHANTY.
1993. “Deregulation and the Opportunities for Commercial Bank Diversification.” Federal Reserve Bank of Atlanta
Economic Review 78 (September/October): 1–25.
WHALEN, GARY. 1999a. “The Risks and Returns Associated
with the Insurance Activities of Foreign Subsidiaries of
U.S. Banking Organizations.” Office of the Comptroller of
the Currency. Unpublished paper.
———. 1999b. “Trends in Organizational Form and
Their Relationship to Performance: The Case of Foreign
Securities Subsidiaries of U.S. Banking Organizations.”
Journal of Financial Services Research (September/
October): 181–218.
LADERMAN, ELIZABETH S. 2000. “The Potential Diversification and Failure Reduction Benefits of Bank
Expansion into Nonbank Activities.” Federal Reserve
Bank of San Francisco Working Paper 2000-01, January.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
51
The Shifty
Laffer Curve
Z S O LT
B E C S I
The author is an economist in the regional section of
the Atlanta Fed’s research department.
It has been said that the virtue of the Laffer curve is that
you can explain it to a congressman in half an hour
and he can talk about it for six months.
—Hal Varian, Intermediate Microeconomics
W
ITHOUT TAXES THERE ARE NO GOVERNMENT SERVICES.
PEOPLE
UNDERSTAND THIS
REALITY BUT ALSO PREFER TO GET THE MOST FROM THEIR GOVERNMENTS AT THE
LEAST COST. IN THE
UNITED STATES,
ANY NUMBER OF POLITICIANS AT THE LOCAL,
STATE, AND FEDERAL LEVELS OWE THEIR SUCCESS TO EMPHASIZING TAX CUTTING.
According to logic, this voter response means that
people are opting for fewer government services
across-the-board or are voting for changes in the mix
of services rendered. It is at this point that things
become complicated because what happens to
expenditures influences how much revenue a government needs to collect. In other words, tax policy
cannot be made in isolation from expenditure policy
because the mix of expenditures affects economic
activity and thus the revenue yield from tax policy.
To understand the impacts of tax policy, one
needs to know what determines tax revenues. A
good place to start is with what is popularly known
as the Laffer curve, which shows how tax rates and
tax revenues are related.1 Essentially, the Laffer
curve posits that as tax rates rise continuously from
zero, tax revenues rise up to some maximum after
which tax revenues fall. This curve became famous
early in the 1980s when supply-side theorists argued
that lower tax rates would mean higher revenues
because existing rates were too high to maximize tax
revenues—that is, tax rates were so high that fewer
taxed goods were being produced and the overall
effect was lower tax revenues. While conceptually
simple, the Laffer curve came under increasing
scrutiny after tax cuts based on supply-side arguments apparently failed to “deliver the goods.” Tax
rates fell but tax revenues did not rise accordingly,
and the United States resorted to deficit spending.
In part, the expected outcome did not occur because
there are important theoretical limitations that produce the deceptive simplicity of the Laffer curve.
This article examines the macroeconomic and conceptual issues that may have made a difference.2
Understanding these considerations may shed more
light on why the 1980s supply-side experiment did
not produce the desired results. It should also help
frame future budget discussions.
Because most analyses of the Laffer curve occur in
a static framework that has proved inadequate, this
analysis presents a simple dynamic model that resembles the discussion in Baxter and King (1995). This
framework is useful for analyzing the long-run effects
of tax policies.3 In addition, the model can easily be
extended to analyze the disposition of government
revenues and the consequent effects on national
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
53
income. It turns out that how the government spends
its tax revenues—on consumption, investment, or
transfers—is important for understanding the Laffer
curve. In fact, a different Laffer curve is associated
with the different ways revenues are spent, and it is
important to know which curve one is operating on
when designing tax policies. Otherwise, one might be
riding the wrong curve, so to speak, and thus miscalculating revenue effects.
Background
erhaps one of the first things one learns in
studying the economics of taxation is that taxes
alter equilibrium prices and quantities of taxed
goods. A tax on any good x introduces a tax wedge
between the price demanders pay and the price suppliers receive. Thus,
the equilibrium quantity of good x will fall
unless demand or supply is perfectly inelasTax policy cannot be made
tic. When the tax rate
is adjusted upward,
in isolation from expenditure
tax revenues will rise
policy because the mix of
as long as the perexpenditures affects ecocentage rise in the tax
rate exceeds the pernomic activity and thus the
centage fall in quanrevenue yield from tax policy.
tity. However, as one
lets the tax rate rise at
a given percentage
rate, the quantity of x
falls, implying that the
percentage change of quantity will rise. At some
point the percentage fall in quantity dominates the
percentage rise in tax rates so that further tax rate
increases cause tax revenues to fall. At the point at
which tax revenues begin to fall, tax revenues are at
a maximum.4 This revenue-maximizing point is a
sort of Holy Grail for policymakers interested in
defending the impact of various budgetary reforms.
One can easily see these points in a simple
demand-and-supply graph (see Chart 1). The intersection of supply and demand gives the before-tax
equilibrium quantity, Q*, and price, P*. Introducing
a tax drives a wedge between the price demanders
pay and the price suppliers receive. Thus, a tax
causes equilibrium quantity to fall to Q** and the
before-tax price to rise to P**. The after-tax price is
the before-tax unit price after taxes have been subtracted, or P** – T. At Q** the amount of tax revenues collected is given by the rectangle Q** × T. As
can be easily verified by comparing rectangles for
different tax rates, tax revenues first rise as tax
rates are raised from small levels because the tax
P
54
rate effect on revenues tends to dominate. But after
a while tax revenues start to shrink because the
quantity effect dominates the tax rate effect.
The rate at which the revenue-maximizing point
occurs determines whether tax rates for a given
product should be raised or lowered from current
levels. The answer depends in part on the relative
demand-and-supply elasticities, or how sensitive
quantity demanded or supplied is to price changes.
Generally, the more inelastic and the steeper the
curves are, the higher the revenue-maximizing tax
rate is. This relationship holds because the percentage reduction in quantities tends to be small and less
likely to dominate a given tax rate change than if
curves were more elastic. This pattern can be easily
verified by drawing steeper demand or supply curves
in Chart 1 and comparing rectangles for a given tax
rate. As a rule, demand or supply curves tend to be
more inelastic the more broadly the tax is defined or
the fewer substitution possibilities there are (either
on the supply or demand side). For example, the
revenue-maximizing tax rate on chocolate bars will
tend to be lower than the revenue-maximizing tax
rate on food, both of which in turn are likely to be
lower than the revenue-maximizing rate on cigarettes.
Similarly, the revenue-maximizing state sales tax
rate should be lower than for federal sales taxes
given that people can avoid state taxes by moving.
The theoretical Laffer experiment deals only with
the effects on revenues from changing tax rates.
However, in the real world tax rates are usually not
changed in isolation. What the government does with
the revenues it receives will also determine where
revenues are maximized. So far it has been assumed
that the government did nothing with its revenues so
that expenditures had no effects. This scenario is
essentially like assuming that the government wastes
its revenues, no better than throwing them into the
ocean. If instead tax revenues were returned lumpsum to taxpayers, or in a way that would not affect
taxpayers’ behavior, the negative wealth effects of the
tax would be offset. This approach would increase
tax revenues relative to throwing the money away.
However, because the taxed activity has become
more expensive relative to untaxed activities, a substitution effect remains whereby the quantity of the
taxed activity falls relative to all other activities.
But what if the government actively spends its
revenues, as it invariably does? If the government
uses revenues to buy more of the taxed good, it will
increase the demand for the good. This move will
tend to offset the decline in quantity caused by the
tax increase, and both tax revenues and the revenuemaximizing tax rate will tend to rise. Finally, if the
revenues are used to add to the public capital stock,
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
C H A R T 1 Derivation of Laffer Curve
D
C
P3**
Supply
B
P2**
Price
A
P2**–T2
Implies
C
Revenues
P4**
•
Demand
B
D
•
P3**–T3
•
P4**–T4
A
Q4**
Q3**
Q2**
Q*
0
Quantity
T2
T3
T4
1
Tax Rate
the supply of good x may increase and, again, the
quantity decline will be offset and the revenuemaximizing tax will tend to be higher.5
Graphically, when revenues are used by the government to increase demand, an outward shift
occurs at the same time the tax is imposed. As seen
in Chart 2, the shift in demand counteracts the
quantity reduction when taxes are raised in isolation. Thus, equilibrium quantity falls by a lesser
amount than before. Also, as can be seen by comparing revenue rectangles, tax revenues rise by a
larger amount than if no taxes are raised. This
observation suggests that the revenue-maximizing
tax rate under a balanced-budget policy is higher
than if expenditures do not keep pace with tax revenues.6 Alternatively, when revenues are used to
increase the supply of the good, the supply curve
shifts to the right instead of the demand curve.
However, the qualitative result is the same.
Fullerton (1982) summarizes the Laffer curve
literature. For the most part, this literature was
comfortable with the assumption that tax revenues
adjust smoothly to tax rate changes.7 Strong
assumptions about the shape of individual preferences and firm-production functions were employed
by theorists and empiricists alike. This literature
also tended to use mostly static frameworks. Thus,
the focus of the research was to empirically investigate the shape of the Laffer curve and determine
where current tax rates were on this curve. The
majority of the papers found that for U.S. income
taxes, tax rates were on the upward-sloping portion
of the Laffer curve. Thus, it was assumed, a reduction of income tax rates would lower tax revenues.
With Malcomson (1986), studies began probing the
strong assumptions leading to a simple Laffer curve
using static general equilibrium models.8 Guesnerie
and Jerison (1991) show for general demand functions
and technologies that Laffer curves can have many
shapes. Their argument is consistent with the idea
that when the Laffer curve exhibits several peaks,
moving to one peak may not maximize revenues
1. The idea behind the Laffer curve has been around for a long time, as long as 200 years by some accounts. See Fullerton (1982)
and Blinder (1981) for historical references.
2. There are also empirical limitations, but the focus of the article is on the macro and conceptual issues.
3. The model is also simple enough to allow an explicit solution. It is related to simple models found in Becsi (1993) and Koenig
and Huffman (1998). While supply-side arguments for lowering tax rates rely heavily on the growth effects of fiscal policies,
the model can easily be extended along the lines of Ireland (1994).
4. The existence of a revenue-maximizing point can be proved using elementary calculus. All that is needed is the assumption
that tax revenues are a continuous and differentiable function of tax rates. Also, tax revenues must be zero when tax rates
are zero or when tax rates are at some very high rate. With these assumptions, Rolle’s Theorem states that there exists a tax
rate such that tax revenues are maximized.
5. Of course, raising public capital may also affect demand inasmuch as it affects the utility derived from good x. Symmetrically,
public consumption may affect the supply side. Thus, public consumption and investment will be treated symmetrically in
utility and production in this article.
6. In the case of very high tax rates, where higher rates in isolation mean lower revenues, a balanced-budget approach might
cause an offset to the reduction in tax revenues.
7. In other words, the mathematical assumptions of Rolle’s Theorem (see Blinder 1981) were respected.
8. See also Malcomson (1988), who shows that the tax function could be discontinuous at some tax rates.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
55
CHART 2
Tax Revenues with and without
Government Spending
This formulation says that as the µi parameters rise,
public services substitute more closely for a unit of
private consumption. Similarly, total output is
defined as the sum of private output produced for
profit, y, and output produced as a direct by-product
of government activities:
Tax Rate
E
{{
T3
•
•
A
T2
•
Demand
Q2** Q3** Q*
Quantity
globally unless it is the highest one. Finally, Gahvari
(1989) shows that how the budget is balanced when
tax rates are changed will affect the shape of the Laffer
curve. In particular, a lump-sum transfer leads to a normally shaped Laffer curve while government consumption may eliminate the downward-sloping portion.
Essentially, the positive effects on production of an
increase of government spending may dominate the
contractionary quantity effects of rising tax rates. If the
expansionary effects are strong enough, an increase in
tax rates will always be associated with an increase in
total revenues. This article elaborates on this last view.
Description of the Model
his section develops a simple dynamic macroeconomic model consisting of household,
production, and government sectors. To
study the long-run effects of taxes, attention is
turned to the steady-state equilibrium of the model
where all variables are constant through time.
Despite its simplicity, the model is a useful starting
point for analyzing the steady-state effects of various fiscal policies. In particular, it allows one to
explore the Laffer curve in a long-run context and
also illustrates how the Laffer curve depends on the
disposition of tax revenues.
To start the analysis of how public expenditures
affect household and firm decisions, it is useful to
look at broad measures of consumption and output.
First, composite consumption is defined as private
consumption, c, plus the services derived from public consumption, cg, and public capital, kg.9 In short,
composite consumption, x, is given by
T
x ≡ c + µ c c g + µ k k g.
56
y + Ac c g + Ak k g.
Supply
B
This formulation says that a unit of government
expenditures will increase total output by Ai. In
other words, Ac is the marginal product of public
consumption, and Ak is the marginal product of public capital. While this specification is very simple, it
has the drawback that private and public output are
substitutes.
It is assumed that households would like to maximize composite consumption and leisure obtained
in each period of their lives.10 However, they are
constrained by their budgets. In other words, purchases of consumption goods and savings can never
exceed after-tax earnings from working and past
savings. The solution of this problem leads to wellknown optimality conditions for constrained utility
maximization: the marginal rate of substitution
(MRS), which equals the ratio of the marginal utilities of two goods, is equated to the price ratio of the
two goods. In other words, the MRS is the rate at
which the individual is willing to sacrifice one good
in return for another to keep lifetime utility constant. The price ratio is the rate at which the two
goods can be substituted and still satisfy the budget
constraint. The difference between the MRS and the
price ratio is that the former is determined by individuals’ tastes and the later is determined by the
marketplace. Optimality means simply that tastes
and market realities are in harmony.11
Optimality forces households to adjust consumption and labor until the marginal rate of substitution
of composite consumption and leisure is equal to
the after-tax wage rate:
MRSh = (1 − t y )w,
(1)
where h is the fraction of time a person spends
working. Alternatively, 1 – h is the fraction of time
devoted to leisure. To understand this equation,
consider what happens when an individual works
more. Suppose the increase in work time is ∆h. In
this case utility will fall with the reduction in leisure
time unless consumption rises sufficiently.
Consumption must rise by MRSh × ∆h to keep utility
constant. Thus, MRSh gives the desired increase in
consumption for a unit increase of labor (or unit
loss of leisure). Alternatively, the budget constraint
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
indicates that if labor rises by ∆h, after-tax labor
earnings will rise by (1 – ty)w∆h units. Thus, consumption can rise only as much as labor income.
To see that individuals will adjust their consumption and labor until the MRS equals the price ratio,
suppose that the MRS is smaller than the price ratio.
In this case, a given reduction of leisure will be
rewarded with more consumption (from additional
wages) than individuals require to keep utility constant. Thus, they will work more because overall
utility rises when work effort and consumption are
increased. As labor and consumption are increased,
the MRS rises because leisure is scarcer and further
sacrifice requires more consumption in order to
keep utility constant. Finally, the MRS will rise until
condition (1) is satisfied.
Households adjust consumption and savings
across time until the MRS of consumption in adjacent periods equals the after-tax interest rate:
budget constraint allows. Thus, current consumption
will be raised relative to future consumption.
In the production sector firms use labor and
private capital to produce their output. Competitive firms vary their labor and capital mix until
profits are maximized. Profit maximization by the
firm implies that the firm adjusts inputs until its
marginal products equal its factor costs. These
conditions can be succinctly represented with a
small amount of notation. The marginal product of
labor is denoted MPh and is the additional output
from varying labor by one unit. Similarly, MPk is
the marginal product of physical capital. Also, the
unit cost of labor is the wage rate, w, and the cost
of capital is the rental rate, r. With this notation,
firms maximize profits when
MPh = w
(3)
MPk = r.
(4)
and
MRSx = r(1 − t y ).
(2)
The logic behind this condition is similar to that of
condition (1). When current consumption is reduced
by ∆x, the next period’s consumption must rise by
–MRSx × ∆x to keep utility constant. In steady state,
the MRSx reflects an individual’s impatience to consume early. An impatient household requires a higher
return for a sacrifice of current consumption. From
the budget constraint, decreasing current consumption by ∆x allows the household to increase savings by
∆k = –∆x. An increase in savings will cause next
period’s earnings to rise by r(1 – ty)∆k, which is the
increase in capital earnings from additional savings.
Thus, the price ratio in equation (2) measures how
much additional future consumption one can have if
current consumption is reduced by one unit. If condition (2) does not hold with equality, then households
will adjust their savings. For instance, if the MRS
exceeds the price ratio, then the individual requires
more future consumption to keep utility constant for
the unit sacrifice of current consumption than the
Intuitively, when the firm is in a situation in which
the marginal product of an input exceeds the unit
cost of the input, profits can be raised by hiring
more of the input in question. As more of the input
is employed, the marginal product tends to fall
because of diminishing returns. Hiring of the input
will proceed until the marginal products again equal
marginal costs.
Finally, the public sector pursues a balancedbudget strategy and purchases consumption and
investment goods and makes lump-sum transfers, l g,
from the proceeds of its income tax collections. The
government’s budget constraint is described by
c g + k g + l g = t y ( wh + rk),
(5)
where the right-hand side of the equation depicts
the source of tax revenues from labor and capital
income and the left-hand side shows uses of funds.
9. The public good aspects of public consumption such as spending on health care, housing, education and defense will affect
individual utility. Some of these expenditures will be closer substitutes for private spending than others. The services from
public capital such as highways and streets, educational structures, and public utilities could also enter private utility.
10. Literally, it is assumed that lifetimes are infinite, an assumption that can be viewed as a useful abstraction of long lives. In
addition, technically oriented readers will find it useful to know that the model assumes that lifetime preferences are
intertemporally separable and that preferences over consumption and leisure are logarithmic. Furthermore, production is
Cobb-Douglas (see the appendix), and capital depreciates fully in each period. As is well known, these popular assumptions
yield an explicit solution and can be a useful starting point for dynamic analyses. However, it must be noted that the strong
assumptions on the form of the utility and production functions may limit the shape of the associated Laffer curves.
11. Again note that long-run optimality conditions are derived by assuming that a steady state exists. A household is in steady state
when asset holdings do not change across time; thus, consumption, labor, and savings are time invariant and time subscripts
can be dropped.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
57
All markets are assumed to equilibrate in all
periods. Thus, aggregate demand equals aggregate
supply, or
c + k + c g + k g = y + Ac c g + Ak k g .
(6)
Here total output supplied by firms is given on the
right-hand side. The left-hand side shows private and
government demand. This equation is just another
way of writing the gross domestic product (GDP)
identity with the government sector broken out.
Description of Steady-State Equilibrium
he six equations introduced above are enough
to describe a simple economy in steady state
and deduce the effects of income taxes and
the effects of public
spending.12 Equations
(2) and (4) together
determine the marginal
The Laffer curve became
product of private capfamous early in the 1980s
ital and also the private capital-labor ratio.
when supply-side theorists
Thus, raising the inargued that lower tax rates
come tax rate reduces
would mean higher revenues
the after-tax marginal
product of private
because existing rates were
capital below its equitoo high to maximize tax
librium level. To rerevenues.
store the steady-state
marginal product of
capital, the firms cut
back on capital, thus
causing the capital-labor ratio to rise and the productivity of capital to rise. While the income tax
has a large effect on the productivity of capital,
government consumption and investment do not
have any effect. The effect of these variables on
the model economy is through the GDP identity,
which is considered next.
Once the productivity of capital is determined,
equation (6) determines the share of output that
goes to consumption. Thus, anything that enhances
the productivity of capital will raise the consumptionoutput ratio. Furthermore, an increase in the fraction of output devoted to public consumption or public investment will lower the fraction of output that
goes to consumption. However, care must be taken
to distinguish between demand and supply effects of
government spending. If the marginal product from
public input is zero so that there are no supply
effects, then crowding out of consumption is one-forone. To include supply effects one must also keep
track of the productivity of government spending. If
the marginal product of public services is greater
T
58
than zero, the share of consumption remaining for
output will fall by less than one-for-one. Because it is
likely that the marginal product for public capital
exceeds the marginal product of public consumption,
public consumption will have a greater crowding-out
effect than public capital.
Given the consumption-output ratio, equations
(1) and (3) pinpoint the steady-state level of labor.
The focus is on three ways that labor in this economy
is altered. First, anything that causes the consumptionoutput ratio to rise raises MRSh in equation (1).
Because MRSh exceeds the price ratio, individuals
adjust consumption and leisure to reduce MRSh and
bring equation (1) back to equality. As discussed
previously, households work and consume less and
increase the time devoted to leisure. Second, given
the ratio of consumption to output, a rise in the
income tax rate lowers the after-tax marginal product of labor in equation (3). To restore the equilibrium
marginal product, work effort must fall because of
diminishing returns. At the same time, this falling
work effort lowers MRSh in equation (1) until
households are happy with a lower after-tax marginal
product of labor. Finally, given the consumptionoutput share, increasing the output share of public
consumption or capital tends to raise MRSh. This
effect induces households to substitute away from
consumption toward leisure and to reduce aggregate labor. However, the substitution effect on labor
is offset more when there is a greater decline in the
consumption share.
So far, the equilibrium capital-labor ratio (or productivity of private capital), the equilibrium level of
labor, and the consumption-output ratio have been
determined. Because private output is produced with
private capital and labor, it is easy to find, given that
equilibrium labor and capital and the form of aggregate production are known. Qualitatively, output
changes will reflect input changes, and the effects of
the various policy changes on output will be traced
out below. It is also possible to calculate the effect on
consumption and capital of a policy change because
it is known how the consumption-output ratio and
the capital-output ratio (or productivity of private
capital) respond as well as how output responds.
Finally, it should be noted that although the productivity of capital is not observed, the real (inflationadjusted) interest rate, which in equilibrium reflects
the marginal product of capital, is observed.
Theoretical Effects of Balanced-Budget
Income Tax Changes
A
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
s discussed above, a simple income tax will
cause private inputs to fall. Increasing the
income tax causes the ratio of private capital
to private output to fall and the private capital-labor
ratio to rise because it lowers the after-tax marginal
product of private capital. Because the marginal
product of labor is also lowered and the capitallabor ratio has already been determined, labor must
fall. Thus, output and the private capital stock fall in
the long run. Because the productivity of private
capital falls, the consumption-output ratio rises. The
total effect on consumption seems uncertain
because the share of consumption rises at the same
time private output falls. Normally, these two factors combine to raise consumption (at the expense
of savings and output). Finally, notice that tax revenues rise or fall depending on whether output falls
proportionately less than the tax rate rises.
To keep its budget balanced, the government has
to do something with the revenue change. Thus, the
effects of different expenditure strategies must be
weighed against the effects of the tax rate changes. A
lump-sum transfer or tax has only wealth effects and
does not affect the long-run equilibrium at the margin.
On the other hand, increasing public consumption or
capital will affect the steady state of the economy
much as it was shown to do in the simple demandand-supply analysis at the outset of this paper.
Suppose public consumption adjusts with income
tax rates to balance the budget. While the capitaloutput ratio is unaffected because the after-tax marginal product of capital is unchanged, the consumptionoutput ratio falls since fewer resources are left over.
The share of consumption falls less than one-for-one
if the marginal product of the government expenditures is positive.13 It can be shown that the increase
in the share of public services and the fall of the consumption-output ratio together cause the marginal
rate of substitution of leisure and consumption to fall
below the market wage. Bringing the marginal rate of
substitution back into equilibrium requires increasing consumption, but doing so is only possible by
working more. However, since more labor implies
that the productivity of capital rises, private capital
rises to keep the capital-labor ratio constant. The rise
in private inputs increases income tax revenues and
raises private (and total) output. Thus, an income
tax with budget-balancing public consumption causes
a smaller reduction in GDP than if expenditures did
not change.
How do the effects of public consumption differ
from the effects of public investment? The differ-
ence depends on the relative marginal products of
consumption and investment and on their relative
substitutability with private consumption. It seems
reasonable that the marginal product of public capital is greater than the marginal product of public
consumption. Assume that Ac < Ak and for simplicity
that µc = µk, and let the share of public consumption
and the share of public investment increase equally.
In this case, the consumption-output ratio is crowded
out to a greater extent by a rise in the share of public
consumption than by public investment. This relationship exists because increasing public capital raises
total production more, leaving more resources for
consumption. However, since the consumptionoutput ratio falls more with public consumption, the
marginal utility of consumption rises more. Thus, to
reequilibrate the optimal marginal rate of
substitution, households increase their
work effort more with
A different Laffer curve is
public consumption
associated with the differthan with public inent ways revenues are
vestment. Thus, private capital, labor,
spent, and it is important
output, and consumpto know which curve one
tion rise more when
is operating on when
public consumption is
increased than when
designing tax policies.
the share of public capital rises by an equal
amount. In essence,
since increasing the
share of public capital causes total output to increase
more, private inputs (and output) are required to
rise less than with an equal increase in the share of
public consumption. Since factor incomes rise less
with an increase in public investment than with an
increase in public consumption, tax revenues rise
less, too.
Just as reasonable is the supposition that public
consumption is a closer substitute for private consumption than for public investment. Assume that
µc > µk and for simplicity that Ac = Ak. Thus, increasing the share of public consumption or investment
reduces the share of consumption equally. However,
the marginal utility of consumption rises by a greater
amount with public capital because for a given
increase in public capital composite consumption will
12. The discussion focuses on an illustrative case that allows a closed-form solution (see the appendix). The solution is simplified by assuming that all forms of government expenditure can be written as linear functions, εiy, of “private” output, y. In
this case, it is possible to write all endogenous variables as linear functions of y and then solve for y itself.
13. Since increasing the share of public consumption (or investment) also tends to lower the marginal utility of consumption,
the negative effect on consumption is reinforced.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
59
CHART 3
Laffer Curves under Alternative
Spending Arrangements
fall more than with a decrease in public consumption.
Thus, increasing the share of public capital will
increase labor, private capital, and output more than
an equal increase in the share of public consumption
will. In summary, the expansionary effect of an increase
in public consumption or investment is positively
related to the substitutability with private consumption and with the size of the marginal product. While
it is easy to imagine that µc > µk or that Ac < Ak, it is
more difficult to see what the overall effect might be.
This issue is analyzed in the next section.
•
Revenues
•
Government
Consumption
Government
Investment
•
Evaluating Laffer Curve Experiments
hich of these competing influences on labor,
private capital, and output tends to dominate? It turns out that the net effect of an
increase in the share of public expenditures εi can be
described very simply. It can be shown that in this
simple model the effect of εi on labor, private capital,
and private output is proportional to (1 – Ai – µi) for
i = c, k.14 In other words, the effect of any government expenditure adjusts the pure demand effect by
subtracting a supply effect Ai and a demand substitution effect µi.
A few studies have tried to quantify (1 – Ai – µi).
Overall, the evidence seems to suggest that
A c + µc ≤ Ak + µk.15 Thus, it seems likely that public
consumption will have a stronger positive effect on
labor, private capital, and private output while public
capital will have a stronger positive effect on total
output.16 In particular, increasing public consumption at the expense of public capital will raise private
inputs and tax revenues but lower total output.
This finding has strong implications for the Laffer
curve since the response of total revenues to a
change in the income tax depends on changes in
income from private inputs. Increasing the income
tax rate tends to raise the average tax rate and to
reduce private inputs. As tax rates continue to rise,
the percentage fall in private-factor income eventually dominates a given percentage rise in the income
tax rate. At this point, total revenues will begin to
fall if tax rates rise any further. Since lump-sum
transfers have no long-run macroeconomic effects,
balancing the budget with lump-sum transfers will
not affect the Laffer curve.
In contrast to lump-sum transfers, increasing the
share of public capital will cause private-factor
incomes to rise, offsetting the tax-induced contractionary effect. Thus, with budget-balancing increases
of public capital, tax revenues will be higher than if
lump-sum transfers were used. As indicated in Chart 3,
the Laffer curve with public capital expenditures will
be above the Laffer curve for lump-sum transfers. It
also can be shown that the revenue-maximizing
Lump-Sum
Taxes
W
60
0
1
Tax Rate
income tax rate will be greater when public capital is
used than when it is not. The downward-sloping part
of the Laffer curve occurs at higher tax rates on the
higher curve than on the lower curve. In other words,
it is less likely that tax revenues increase when income
tax rates and public capital are reduced simultaneously
than when lump-sum transfers have been reduced.
Lastly, increasing the share of public consumption
is likely to cause income from private inputs to rise
more than if public capital were increased. Thus, tax
revenues will be higher if government consumption
is used to balance the budget. Equivalently, the
Laffer curve for public consumption lies above the
Laffer curve of public investment (and it can be
shown that the revenue-maximizing tax rate will be
higher, too). This possibility is also depicted in Chart 3
along with the other two possibilities.
Which of the three Laffer curves in Chart 3 is the
correct one for the 1980s under the Reagan administration? Answering this question requires a quick look
at the data, which reveals three important features of
the times. The two well-publicized features are the
federal marginal tax cuts and the deficit-financed
spending (on transfers and government consumption).17 Another important feature of the data for the
period is that public capital investment dropped relative to public consumption, continuing a trend started
in the mid-1960s (see Chart 4).18 Thus, to some
extent higher government consumption was paid for
by lower government investment. When government
consumption is increased at the expense of government investment, the total effect on tax revenues
equals the effect on GDP that is proportional to Ac +
µc – Ak – µk. Because GDP falls, less revenue is collected than before at prevailing tax rates. In essence
such a policy shifts all existing Laffer curves down.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
CHART 4
Nondefense Government Investment as a Share of Total Government Expenditures, 1950–99
Share
0.16
0.14
0.12
1960
1970
1980
1990
Note: This series takes a ratio of nondefense government investment and total government expenditures. Both series include local, state,
and federal expenditures.
Now suppose that the preexisting income tax rate
was higher than it ought to be to maximize revenues.
In other words, suppose that the prevailing tax rate
was on the downward-sloping portion of the Laffer
curve as indicated by point A in Chart 5. Under these
circumstances, lowering the tax rate would tend to
increase revenues. However, if government consumption rises at the expense of government investment,
the Laffer curve shifts down. Thus, rather than rising
on the original curve, tax revenues fall from point A in
Chart 5 to point B. At this point, lowering of tax rates
would still increase revenues. However, the additional
revenues from lowering tax rates would be insufficient
to offset the decline in revenues brought about by the
expenditure switch. Thus, it seems that supply-siders
may have overlooked an important determinant of the
position of the Laffer curve.19
Under the Clinton administration there have
been two developments with implications that can
be explained using the current analysis: tax rates
have risen, and government investment has risen
relative to government consumption.20 If one
14. This relationship can be shown by totally differentiating the closed-form solution in the appendix.
15. Aschauer (1989a, 1989b, 1990) cites evidence that the marginal product of public consumption, Ac, is close to zero and that
the marginal rate of substitution between private and public consumption, µc, is in the range (0.2, 0.4). However, Kuehlwein
(1992) finds no evidence for the substitutability of public and private consumption. Thus, µc is more likely in the range (0,
0.4). To date there exists no empirical evidence on the size and sign of µk. Aschauer (1990) finds that the marginal product
of public capital, Ak, may be close to four. Tatom (1991a, 1991b), however, argues that these estimates may be overstated
by 40 percent, if not more.
16. Notice that when Ak + µk < (>) 1 an increase in public investment will crowd private capital in (out). Aschauer (1989a)
argues that public capital may have two effects. First, if public capital raises the marginal productivity of private capital, it
will crowd private capital in. Second, if public capital rises, it will raise output creating a positive wealth effect for households, which will raise consumption and lower savings. Thus, private capital is crowded out. Aschauer finds that the first
effect comes to dominate over time. While this article does not consider this effect, assuming a small enough Ak + µk is a
rough approximation. For the second effect Aschauer seems to assume that Ak + µk > 1.
17. The calculation abstracts from the deficit-financed increase in government spending because ultimately it must be paid for
with future tax increases, future spending reductions, or higher growth of incomes. Ireland (1994) shows that deficitfinanced increases in government spending will eventually pay for themselves through higher growth. However, it may take
a long time.
18. Note that the chart compares nondefense government investment to total expenditures. Both investment and expenditure
numbers include outlays at the local, state, and federal levels. Also see, for instance, Baxter and King (1995).
19. One implication of this analysis is that empirical studies of the Laffer curve must carefully control for the effects of all types
of government expenditures.
20. This statement refers to Chart 4. Government investment and consumption numbers include expenditures at the local,
state, and federal levels.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
61
CHART 5
Laffer Curve Depicting the Switch from
Government Investment to Consumption
as Tax Rates Are Reduced
Revenues
•
•A
Consumption
•B
Investment
0
1
Tax Rate
believes that the downward-sloping portion of the
Laffer curve is relevant, then such a policy would be
a move from point B to point A in Chart 5. However,
many economists would argue that the United
States is on the upward portion of the Laffer curve.
In this case, the positive effect on tax revenues from
an increase in tax rates would be reinforced by the
shift in government expenditures. In either case, the
analysis suggests higher tax revenues, an outcome
the data bear out.
62
Conclusion
ature and tax policy abhor a vacuum. If tax
policy is designed without reference to
expenditure policy, it is possible that the
effects on tax revenues may be miscalculated. To
make this case, a simple neoclassical growth
model was developed and the long-run effects of
government expenditures and income taxes were
analyzed. It was shown that a reduction of tax rates
would increase income from labor and private capital and would increase output. Reducing public
capital at the same time will tend to lower private
inputs and production and thus lower income tax
revenues, in turn reducing the tax revenues
derived from a cut in income tax rates. The larger
the productivity of public capital is or the more
precipitous its decline, the likelier it is that tax revenues will fall. By this argument, cutting income
taxes at the same time that public investment falls
and government consumption rises, as occurred in
the 1980s, increases the likelihood that the government loses tax revenues. In this case, a revenueincreasing strategy would have been to lower
income tax rates but increase public investment at
the expense of government consumption. As a general rule, raising public investment relative to public consumption will tend to add to tax revenues.
More importantly, realizing that the Laffer curve is
shifty (in the sense that it moves with external
shocks) should lead to better tax-policy design.
N
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
A P P E N D I X
A Closer Look at the Model
Households maximize the utility function
where total output in steady state is
Σ s ≥1(1 / ρ)s −1[ln( cs + µ c cg + µ k ksg−1 ) + α ln(1 − hs )]
subject to a budget constraint that is summarized by
y + y g = (1 + Ac ε c + Ak ε k ) y.
Furthermore, dividing both sides of the government’s
revenue constraint by y implies
cs + ks = (1 − t y )( ws hs + rs ks–1 ) + l sg ,
ε c + ε k + ε l = ty.
where lsg is the lump-sum transfer (or tax), ks–1 is physical capital accumulated up to period s, and ks is the
additional holdings of capital. This equation implies the
following first-order conditions that correspond with
equations (1) and (2) in the text:
MRSh ≡
α / (1 − h )
= (1 − t y ) w,
1 / ( c + µ c c g + µ k kg )
(A1)
and
MRSx ≡ ρ = r(1 − t y ),
(A2)
respectively, with subscripts dropped to indicate that
variables are in steady state.
Firms produce according to a Cobb-Douglas production function, y = kθh1–θ. Under these circumstances
the first-order conditions corresponding to equations
(3) and (4) in the text are
MPh ≡ (1 − θ )( y / h ) = w,
(A8)
Finally, the market clearing conditions now look like
c + k + ε c y + ε k y = (1 + Ac ε c + Ak ε k ) y.
(A9)
As long as the marginal products of the public inputs
are less than unity, the demand effects of public expenditures dominate the supply effects.
Using the last five equations, a closed-form solution
to the model is easily found. The solution proceeds
much like the exposition in the text. From (A6), steadystate capital is a linear function of equilibrium output.
Thus, the average productivity of capital is given by
k (1 − t y )θ
=
.
y
ρ
(A10)
Substituting (A10) into (A9) yields
c / y = 1 − (1 − Ac )ε c − (1 − Ak ) ε k − ( k / y ), (A11)
(A3)
and
which in turn, after substitution into (A5), yields
MPk ≡ θ( y / k) = r,
(A4)
respectively.
Combining household and firm-optimality conditions and imposing a steady state yields
α
(A7)
(c / y + µ c ε c + µ k ε k ) y
= (1 − t y )(1 − θ )( y / h ) (A5)
1– h
h=
(1 − t y )(1 − θ )
(1 − t y )(1 − θ ) + α [(c / y ) + µ c ε c + µ k ε k ]
. (A12)
Then, output can be found by rewriting the production
relationship as
θ
y = ( k / y ) 1− θ h
(A13)
and inserting (A10) and (A12). Finally, consumption
and capital are found by multiplying (A10) and (A11)
with (A13).
and
ρ = (1 − t y ) θ ( y / k),
(A6)
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 2000
63
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@FedFRASER