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1991 Quarter 3
Is There Any Rationale for
Reserve Requirements?
by E.J. Stevens
Government Consumption,
Taxation, and Economic Activity
by Charles T. Carlstrom and
Jagadeesh Gokhale
Deregulation and the Location
of Financial Institution Offices
by Robert B. Avery
FEDERAL RESERVE BANK
OF CLEVELAND
ECONOMI C
REVI EW
1991 Quarter 3
Vol. 27, No. 3
Is There Any
Rationale for Reserve
Requirements?
2
by E.J. Stevens
Reserve requirements have been part of the regulatory apparatus of
banking in the United States for more than 150 years. Currently, how
ever, more than half of all depository institutions are exempt from the
regulation, and a growing number of others meet their requirements
with voluntary holdings of vault cash. In searching for a contemporary
rationalefor reserve requirements, the author finds little to recommend
them other than an aversion to complete reliance on the discount win
dow for meeting banks’ day-to-day liquidity needs.
Government
Consumption,
Taxation, and
Economic Activity
18
by Charles T. Carlstrom
and Jagadeesh Gokhale
Most increases in U.S. government consumption since World War
II, except for those associated with wars, have been permanent.
This paper uses a stylized model of the economy to analyze how
permanent and temporary increases in government expenditure—
and the timing of taxation used to finance them— affect aggre
gate output and other variables that describe the economy.
Deregulation and the
Location of Financial
Institution Offices
30
by Robert B. Avery
Changes in the regulation and structure of the U.S. financial serv
ices industry over the last 15 years have led to allegations that the
banking system has weakened its commitment to poor and minority
consumers, yet little solid evidence has been produced to support
this claim. The author examines this accusation by looking at the
pattern of financial office closures in five metropolitan areas be
tween 1977 and 1990 and finds mixed results.
Economic Review is published
quarterly by the Research Depart
ment of the Federal Reserve Bank
of Cleveland. Copies of the Review
are available through our Public
Affairs and Bank Relations Depart
ment, 216/579-2157.
Coordinating Economists:
Randall W. Eberts
James B. Thomson
Editors: Tess Ferg
Robin Ratliff
Design: Michael Galka
Typography: Liz Hanna
Opinions stated in Economic
Review are those of the authors
and not necessarily those of the
Federal Reserve Bank of Cleveland
or of the Board of Governors of the
Federal Reserve System.
Material may be reprinted
provided that the source is
credited. Please send copies of
reprinted material to the editors.
ISSN 0013-0281
Is There Any Rationale
for Reserve Requirements?
by E.J. Stevens
E.J. Stevens is an assistant vice
president and economist at the
Federal Reserve Bank of Cleve
land. The author thanks Randall
Eberts, W illiam Gavin, Joseph
Haubrich, and Robert Rasche for
useful comments, and Diana
Dumitru for invaluable research
assistance.
Introduction
Reserve requirements have been part of the reg
ulatory apparatus of banking in the United States
for more than a century and a half. No matter
what their original purpose may have been,
maintaining the burden of reserve requirements
needs a contemporary rationale that can justify
the problems they create.
The problems attributed to reserve require
ments are woven into the fabric of financial mar
kets. The burden of meeting the regulation
appears to vary unfairly among banks of compa
rable size. Financial institutions not subject to the
regulation engage in many of the same activities
as those required to hold reserves. Legislative
efforts to overhaul the nation’s banking and finan
cial system would be easier if reserve requirements
could be eliminated from the set of issues to be
considered. Financial reform aside, reducing or
eliminating these requirements might be a way to
improve the profitability of banking and the will
ingness of banks to extend credit while under
pressure to improve capital. Moreover, even if
problem loan and inadequate capital matters were
resolved, many analysts believe that reserve re
quirements
still would impair the international
competitiveness of U.S. banks.
Two obvious approaches to removing the
burden of reserve requirements are to eliminate
them altogether or to pay a market rate of interest
on reserve balances. This article deals only with
the first approach, exploring various rationales
for reserve requirements on the premise that
there would be no point in paying a market rate
of interest on reserves if there were no rationale
for requiring reserves in the first place. Perhaps
because the requirements have been part of the
structure of depository institution markets for so
long, their rationale seems obscure and the effect
of their elimination even more so. Recent elimi
nation of a portion of reserve requirements has
sharpened the issue.1 If a partial elimination was
good, would not complete elimination be better?
After a brief description of the reserve require
ments now in place, the discussion is organized
around their three traditional rationales: taxation,
■
1 In December 1990, the reserve requirement on nonpersonal time
deposits of less than one and a half years’ maturity and on Eurocurrency
liabilities was reduced from 3 percent to zero. In all, the change was esti
mated to have reduced required reserves by almost $14 billion.
TABLE
1
I. The Facts about
Current Reserve
Requirements
Reserve Requirement Coverage,
Fall 1990
Estimated number of depository institutions
34,200
Below $3.4 million exemption
Nonreporting
Reporting annually
Reporting quarterly
19,300
12,100
6,600
600
Not exempt
Reporting quarterly
Reporting weekly
14,900
5,700
9,200
SOURCE: Board of Governors o f the Federal Reserve System.
monetary policy, and liquidity.2 The Federal
Reserve transfers most of its net earnings to the
Treasury, amounting to about $23 billion in 1990.
The portion of the transfer that can be attributed
to the reserve requirement “tax,” though only a
trivial source of Treasury revenue, has had non
trivial distorting effects on financial markets.
The second rationale, monetary policy, be
came the explicit and only statutory justification
for reserve requirements in 1980, although with
out the requirements, policy could continue to
operate just as it does today. Only if monetary
policy were to operate in a way in which it has
never operated in the past could reserve require
ments be rationalized as a way to improve the
short-run accuracy of policy implementation.
Finally, and contrary to traditional assertions,
modem reserve requirements serve a short-mn
liquidity function by ensuring a pool of balances
for daily private-market distribution to credit
worthy illiquid institutions. This liquidity function
can be used as a rationale for reserve require
ments, however, only if there is reason to avoid
relying solely upon the alternatives of daily open
market operations and discount window lending
to meet the banking system’s liquidity needs.
2 Goodfriend and Hargraves (1983) present a thorough examina
tion of the evolution of the liquidity and monetary policy rationales, and
of the revenue aspects of the tax rationale. My assessment of the various
rationales differs from theirs in that I place more emphasis on short-run
liquidity considerations and view the tax rationale from a broader perspec
tive than revenue. Revenue is both smaller than might be inferred from
their discussion and difficult to defend from avoidance.
http://fraser.stlouisfed.org/
Federal Reserve Regulation D governs reserve re
quirements, defining assets eligible to be counted
as reserves and liabilities subject to the requirement.
The Monetary Control Act of 1980 made these
requirements applicable to all commercial
banks, mutual savings banks, savings and loan
associations, credit unions, agencies and
branches of foreign banks, and Edge Act corpo
rations operating in the United States.
Reservable liabilities include transactions
deposits (that is, accounts that allow unlimited
nonautomatic third-party payments), nonper
sonal time deposits, and Eurocurrency liabilities.
However, in December 1990 the required
reserve ratio was set at zero for all but transac
tions deposits. Eligible assets include vault cash
and reserve deposits held at Federal Reserve
Banks. Box 1 provides a more-detailed descrip
tion of the current reserve requirement account
ing system.
More than 34,000 institutions now fall within
the purview of Regulation D (see table 1). How
ever, over 19,000 small institutions are essential
ly unaffected because the Gam-St Germain
Depository Institutions Act of 1982 mandates a
zero reserve ratio for the first $3.4 million of
reservable liabilities of any kind.3 As a result,
many of these small institutions need only com
plete an annual request for data, which allows
the Federal Reserve to monitor compliance and
to update estimates of the monetary aggregates.
The remaining 14,900 institutions must com
ply with reserve requirements on a quarterly or
biweekly basis, submitting quarterly or weekly
accounting records to the Federal Reserve Banks
so that compliance with the regulation can be
monitored on an ongoing basis. In addition,
these same records provide much of the raw data
used in compiling weekly and monthly estimates
of the monetary aggregates, including the m on
etary base, M l, M2, and M3- This information is
important both for the Federal Reserve’s conduct
of monetary policy and for other users’ efforts to
track Fed policy and the economy. Supervisory
authorities monitor reporting accuracy as part of
the normal examination process.
■
Federal Reserve Bank of St. Louis
■
3 Initially, the Act set the 0 percent reserve requirement at $2 m il
lion of reservable liabilities for each institution, with a provision for an
nual adjustment. See Board of Governors of the Federal Reserve System
(1990), table 1.15, footnote 2.
The Details of Required
Reserves Accounting
The Monetary Control Act of 1980 stipulates that
only transactions and nonpersonal time deposits are
reservable, and mandates a further distinction on
the basis of an institution’s size. Reserve require
ments are different for nonpersonal time deposits
than for transactions deposits.
The reserve ratio for nonpersonal time deposits
(including Eurocurrency liabilities) may be set
within the range of 0 to 9 percent and may vary by
the maturity of a deposit.a Prior to December 1990,
the regulation specified a ratio of 3 percent for
deposits with an original maturity of less than one
and a half years, and zero for longer maturities; now
the ratio is zero for all maturities.
The required reserve ratio for transactions
deposits depends on the amount of these deposits
on an institution’s books: 3 percent of the first $40.4
million (of which up to $3.4 million is exempted)
and 12 percent of the amount in excess of the $40.4
million break point.'1 The 3 percent ratio and the
break point are determined by law, but the Board of
Governors has statutory authority to set the higher
ratio within a range of 8 percent to 14 percent.
The transactions deposit reserve required for a
weekly reporting institution is computed from the
average level of transactions deposits during a twoweek computation period that ends every other
Monday. Reserve assets eligible to satisfy this re
quirement are drawn from two sources: 1) the aver
age amount of vault cash held during the two-week
period ended 28 days prior to the end of the compu
tation period and 2) the average amount of reserve
deposits held during the two-week maintenance
period ending on the Wednesday two days after the
end of the computation period. This arrangement,
with the reserve computation and the reserve
deposit maintenance periods overlapping on 12 out
of 14 days, is referred to as a “contemporaneous
reserve requirement.”
The operation of transactions deposit reserve re
quirements may be more readily understood from
the vantage point of a weekly reporting institution
managing its reserve position. The institution enters a
two-week reserve maintenance period knowing the
amount of vault cash eligible to meet its requirement.
After the second day of the computation period, the
institution can begin to maintain reserve deposit
balances against its accumulating transactions
deposit requirement. After the second Tuesday of the
maintenance period, the institution knows the full
amount of reserves it must hold to meet the transac
tions deposit requirement, as well as the amount of
reserve deposits it has held over the first 12 days of
the maintenance period. The institution then has the
opportunity to adjust its reserve deposit balance on
the remaining two days of the period to make re
serves held equal to the requirement (plus or minus
any eligible carry-in and any desired carry-out).
Quarterly reporting institutions operate on a
lagged reserve accounting basis. Computation is
based on deposits held during a single seven-day
period beginning the third Tuesday of March, June,
September, and December of each year. Vault cash
held during that same seven-day period is deducted
from required reserves. Any remainder becomes the
required reserve deposit balance to be held on a
daily average basis throughout 13 weekly mainte
nance periods beginning the fourth Thursday follow
ing the end of the computation period and ending
the day before the next set of 13 maintenance
periods begins.
a. Eurocurrency liabilities are a measure o f the net foreign funding o f U.S. creditors through international facilities o f U.S. institutions
and through U.S. facilities of foreign institutions.
b. The break, originally $25 million, must be adjusted no later than December 31 o f each year by 80 percent o f the percentage increase
or decrease in total transactions accounts of all depository institutions in the calendar year ending the previous June 30.
NOTE:
A more complete description of reserve accounting can be found in Meulendyke (1989), pp. 127-36.
TABLE
2
Composition of Vault Cash
and Deposits at Federal Reserve
Banks, All Depository
Institutions, May 1991
Millions of dollars
Total vault cash and deposits
56,514
Required reserves
Applied vault cash
Reserve deposits
48,033
26,775
21,258
Other
Clearing balances
Surplus vault cash
Excess reserve deposits
8,481
3,504
3,949
1,028
NOTE: Data are m onthly averages of biweekly maintenance period
averages. Vault cash includes only the am ount held by those depository
institutions subject to reserve requirements. The maintenance period in
w hich vault cash can be used to satisfy reserve requirements ends 30 days
after the close of a biweekly computation period during which the vault
cash was actually held.
SOURCE: Board o f Governors o f the Federal Reserve System.
Accurate record-keeping is important to each
institution, and not just to avoid supervisory dif
ficulties. Missing the required reserve target can
be costly: Reserve deficiencies are penalized at a
rate two percentage points above the discount
rate, while excess reserves do not earn interest.
Some leeway is provided through a carryover
provision, however. This allows a weekly report
ing institution to carry over (for one period only)
a deficiency of up to 2 percent of its required
reserves by holding an equivalent amount of
excess reserves in the next reserve maintenance
period, or to use excess reserves of up to 2 per
cent in meeting its reserve requirement in the
next period.4
■
4 The 2 percent carryover provision gives a bank considerable lee
way in the deposit balance it must maintain at the Fed on any single day
of a 14-day maintenance period. A bank entering a period with no carry
over, meeting 55 percent of its required reserve with vault cash (the
recent aggregate average), and holding the required amount of deposits
on a daily average basis for 13 days of the period could allow its deposit
balance on the fourteenth day to deviate from the daily average required
amount by as much as 62 percent ( = { [ .02 x 14 ] / [ 1 — .55 ] } x 100 )
and still not waste excess reserves or be penalized for a reserve deficiency.
However, any bank that meets more than 72 percent of its required reserve
with vault cash would be unable to take full advantage of this leeway to
cover a single-day reserve deficiency because to do so would mean hold
ing a negative balance on that day.
Required reserves are far larger than deposi
tory institutions’ holdings of reserve deposits at
Federal Reserve Banks for several reasons. First,
more than half of aggregate reserve require
ments in a typical maintenance period are satis
fied by vault cash holdings (see table 2). In fact,
many institutions meet more than 100 percent
of their requirement in this way. Less than 90
percent of eligible vault cash is actually applied
toward meeting requirements; the remainder is
surplus vault cash (not included in measured ex
cess reserves) held by institutions whose portfo
lios are not bound by reserve requirements.
These “unbound” institutions, including some
of the largest weekly reporters, voluntarily hold
cash inventories for their teller stations and auto
mated teller machines that more than satisfy
their reserve requirements.
Second, about 15 percent of depository insti
tutions’ aggregate deposit balances at Federal
Reserve Banks are not in reserve deposit ac
counts but in clearing accounts that yield earn
ings credits used to offset charges for Reserve
Bank services. Maintaining a clearing account
provides direct access to these services for insti
tutions that do not need reserve accounts, or
supplements a required balance in order to
reduce the likelihood of daylight or overnight
overdraft problems. An institution arrives at the
appropriate level of its clearing balance, in con
sultation with its Reserve Bank, on the basis of
size and the volume and intraday pattern of its
transactions. Once determined, the agreed-upon
balance must be maintained on an average
daily basis during a reserve maintenance period
in the same way as for required reserves.5
Finally, about 4 percent of depository institu
tions’ aggregate deposit balances at Federal
Reserve Banks are simply excess reserves. Aggre
gate excess reserves tend to fluctuate around a
relatively stable level that is related not to the
level of interest rates, but to the distribution of
excess reserves among different kinds of institu
tions in response to calendar-related regularities
in payment flows and balance-sheet “window
dressing.” In effect, the typical excess reserve
level is simply the combined “small change” in
the accounts of many institutions.6 O n the last
day of a maintenance period, each holder of
■
5 Earnings credits are calculated from the average federal funds rate
for the maintenance period during which balances are held. Clearing bal
ances are subject to the same 2 percent carryover provisions as required
reserves. However, earnings credits on clearing balances that are not used
to offset service charges during the maintenance period can be carried for
ward up to 52 weeks.
■
6 For a recent explanation of the determinants of excess reserves,
see Partlan, Hamdani, and Camilli (1986).
excess reserves apparently is either unsure of its
exact position, or finds that the federal funds
rate is insufficient to offset the cost of placing its
small amount of excess funds in the market.7
II. The Tax
Rationale for
Reserve
Requirements
In a sense, banks are taxed when they are re
quired to hold more non-interest-bearing eligible
assets than they would maintain in the absence
of reserve requirements. As already noted, not
all banks are in this situation: Some voluntarily
hold more reserve assets than required and thus
are not bound by the requirements. Moreover,
even for bound institutions, not all reserve assets
represent involuntary holdings, because banks
would undoubtedly hold inventories of vault
cash even in the absence of reserve require
ments. Apart from these observed and unob
served voluntary holdings, however, reserve
requirements must tax some combination of
bank owners, depositors, and borrowers.
One could argue that the level of many banks’
reserve deposits is not substantially different
from that needed for clearing purposes and that
reserve deposits are therefore not a tax, even
though overnight holdings of Fed deposits do
not earn interest. It is more likely, however, that
in the absence of binding reserve requirements
and with the interest-rate levels typical of the last
40 years, banks would find it cheaper to alter the
mechanisms of clearing and settlement than to
continue to bear the opportunity cost of holding
non-interest-bearing overnight Fed deposits.
The repercussions of the tax depend on its in
cidence, detenuined by elasticities both of the
supply of reservable deposits and of the demand
for loans and other services (hereafter referred to
simply as “loans”). At one extreme, if financial
markets provided perfect substitutes for banks’
reservable deposits and loans (perfectly elastic
supply and demand, respectively), the tax could
not be passed on to customers, and the incidence
■
7 Every institution always has an incentive to minimize its excess
reserves, because excess reserves earn no interest. The carryover provision
of the reserve accounting regulation provides one avenue for an interestrate influence. For example, if an institution foresees higher interest rates in
the immediate future, it might try to use excess reserves to prefinance the
allowable portion of its next-period reserve requirement. Alternatively, it
might hold excess reserves to offset a deliberate reserve deficiency in the
previous maintenance period that was induced by expectations of an
interest-rate decline. Such deliberate manipulation cannot exert a continu
ous influence on a single institution’s reserves because neither excesses
nor deficiencies can be carried over for more than one maintenance period.
http://fraser.stlouisfed.org/
Federal Reserve Bank of St. Louis
of the tax would be on the profitability of bank
ing. This would be reflected in the number and
value of bank charters. At the other extreme, if
banks were sufficiently unique to ensure that
financial markets provided no substitutes for
reservable deposits or bank loans (perfectly in
elastic supply and demand), the whole tax could
be passed along to bank customers, and the in
cidence of the tax would be on them. Phrasing
the matter slightly differently, the more elastic
the supply of reservable deposits and the
demand for bank loans, the more the tax will
distort financial flows by diverting bank business
to other financial instruments or markets 8
Distortions in the
Allocation of Funds
Postwar history provides a wealth of financial
developments that can be attributed, at least in
part, to the distorting effects of reserve require
ments.9 The Monetary Control Act of 1980 may
be viewed as one response to several of these
distortions. Until the Act was passed, Regulation
D applied only to commercial banks that were
members of the Federal Reserve System. Mem
bership was mandatory for national banks but
voluntary for state-chartered banks. The burden
of meeting reserve requirements was one of the
factors thought to have contributed to steady
erosion in membership of state banks and in
chartering of national banks.10 The Act ex
tended coverage of reserve requirements to all
commercial banks, members and nonmembers
alike, in effect reducing elasticities of the supply
of reservable deposits and of the demand for
bank loans at member banks.
The Monetary Control Act also extended
coverage of reserve requirements to thrift institu
tions. Until 1980, thrifts were subject to less
burdensome reserve requirements imposed by
■
8 Recent discussions of a “credit crunch" sometimes reflect differ
ing views about these elasticities. Those arguing that a crunch should not
concern policymakers may assume that the elasticities are large enough
to ensure that most borrowers not serviced by banks w ill be accommo
dated elsewhere. Those recommending that a crunch be offset through
monetary policy and supervisory actions may assume that the elasticities
are small enough to ensure that many borrowers not serviced by banks
will not be serviced at all.
■
9 The first (unsuccessful) attempt to legislate federal reserve re
quirements in the United States was motivated by a desire to "distort’’ the
state-chartered "Pet Banks" out of existence and thereby to defeat Andrew
Jackson’s repudiation of the Second Bank of the United States (Stevens
[forthcoming]).
■ 10 A representative statement of this position can be found in
Volcker (1980).
TABLE
3
Allocation of Funds: Secular
Growth of Debt Instruments and
Lending Sectors, 1952-1990
Debt Instalments
Percentage
Change“
Credit market debt owed by
nonfinancial borrowers in the form of:
U.S. Treasury and agency securities
Corporate bonds
Bank loans
Consumer credit
Tax-exempt securities
Mortgages
Commercial paper
Total domestic debt instruments
Foreign debt instruments
Domestic plus foreign debt instruments
6.5
8.3
8.8
8.8
9.0
10.1
16.5
8.4
7.8
8.4
Lending Sectors
Credit market debt claims against
nonfinancial sectors held by:
Commercial banks, including reserves
Required reserves
Reserve deposits
Vault cash
Commercial banks, excluding reserves
Private domestic nonfinancial sector
Insurance and pension funds
Savings institutions
U.S. government, agencies, and
the Federal Reserve
Other financial sectors
Foreign holders
7.9
2.8
1.3
6.7
8.3
8.3
8.7
9.1
10.0
13-4
13-7
a. C om pound annual rate.
SOURCE: Board o f Governors o f the Federal Reserve System.
individual states and Federal Home Loan Banks.
New England thrifts pioneered in the develop
ment of interest-bearing transactions accounts,
which were free of member-bank reserve re
quirements. Member commercial banks, in com
petition, also devised variations of savings
accounts to take advantage both of the lower
reserve requirements on savings than on trans
actions deposits and of the ability to pay interest
on savings accounts.11
O f course, reserve requirements were not the
only force at work in shifting deposits from
member banks to nonmember banks and thrift
institutions, and from transactions accounts to
variants of savings accounts. High nominal inter
est rates in an inflationary environment certainly
stimulated efforts to avoid both the prohibition
of interest on demand deposits and the oppor
tunity cost of holding non-interest-bearing
required reserves. The increasing power and
declining cost of telecommunications technol
ogy made it economically feasible to sweep
balances back and forth between accounts and
institutions in order to minimize reservable bal
ances and to pay interest. But member banks’
desire to avoid reserve requirements on par
ticular kinds of deposits was clearly an impor
tant factor in the evolving distribution of funds
among types of accounts and types of deposi
tory institutions, as well as between deposits
and safe, liquid securities.
Furthermore, the distorting effect of reserve
requirements has not been restricted to the
deposit side of intermediaries’ balance sheets.
In the 1960s, sales of loans to a bank’s affiliates,
with affiliate financing from nondeposit sources
such as commercial paper, assumed substantial
scale. One clear advantage of this arrangement
was that it enabled a banking organization to
avoid the reserve requirement, until the require
ment was extended to this source of funding in
1970. The same was true of loans booked at
foreign affiliates and funded by offshore dollar
deposits, until reserve requirements were ex
panded to cover this distortion also.12
Today, an analogous pattern of financing
carried out by unaffiliated foreign banks is cited
as evidence that reserve requirements place
domestic banks at a disadvantage in competing
with foreign banks. Similarly, growth of the
commercial paper market and of direct lending
by life insurance companies and pension funds,
all relative to slower secular growth of bank
lending, is cited as evidence of reserve require
ments’ possible distorting effect on the pattern
of financial intermediation and credit flows in
the economy.
Some suggestion of distortion can be seen in
data from the Flow of Funds Accounts, available
on a consistent basis since 1952 (table 3). This
information can only describe what has been,
not what would have been in the absence of
reserve requirements. The trend of bank loan
■
11 Distortions of this kind were not unique to the postwar period.
The low 3 percent reserve requirement against time and savings deposits
after 1917 led to cases “ ... where, to meet the competition of State savings
banks, some member banks... devised a special savings account on which
checks [could] be drawn without the presence of the depositor at the bank.
These accounts [were] evidenced by savings passbooks in which the bank
reserve[d] the right to require 30 days' notice before making payment on a
withdrawal. When the account [was] opened, a duplicate passbook [was]
left with the bank, which enter[ed] therein the amount of each withdrawal at
the time checks on these accounts [were] presented for payment.” See
Committee on Bank Reserves of the Federal Reserve System (1931), p. 15.
■
12 These provisions are discussed in Board of Governors of the
Federal Reserve System (1971), p. 19.
FI GURE
1
Reserve Requirement
Tax as a Percentage of
Government Receipts
Percent
NOTE: For further explanation o f the estimates plotted here, see appendix.
SOURCES: U.S. Treasury Department; Office of Management and Budget;
and Board of Governors o f the Federal Reserve System.
growth has been lower than the growth trends
of mortgages, tax-exempt securities, commercial
paper, and other miscellaneous instruments;
only the lower growth trend of government and
agency securities allowed bank loan growth to
be slightly higher than for all debt instruments
combined. Commercial bank holdings of claims
on all nonfinancial borrowers — a rough meas
ure of the size of the banking system from the
asset side of the balance sheet — have grown
somewhat more slowly than the holdings of any
other intermediary group. More striking is evi
dence of successful efforts to minimize the
reserve requirement tax; The combined reserve
deposits and vault cash assets of commercial
banks have grown at only about one-third the
rates of growth of bank loans and, indeed, of
the banking system, largely because the growth
rate of reserve deposits has averaged only 1.3
percent since 1952.
The Nature of the Tax
A pure revenue, “seigniorage” rationale for the
reserve requirement tax seems weak. Congress
has not shown a strong interest in using reserve
requirements as a deliberate means of raising
revenue. As noted in the preceding section, ero
sion of the tax base, reflecting the competitive
ingenuity that is characteristic of private markets,
was repaired by the Monetary Control Act of
1980. However, because this repair was accom
panied by reduced tax rates (required reserve
ratios), revenues attributable to reserve require
ments have not kept pace with other Treasury
revenues. As a percentage of Treasury revenue,
the tax has never yielded as much as 1 percent
and has fallen by more than half since 1974,
averaging slightly less than four-tenths of 1 per
cent in the 1980s (figure l) .13
Calling reserve requirements a tax may be
something of a misnomer because their ration
ale may not be revenue, but an implicit license,
or user, fee. Just as trucks pay taxes to use the
nation’s highways, so too may banks (more
properly, depository institutions since 1980) pay
a reserve requirement tax to use unique govern
ment services. These include the Federal Reserve
services of settlement, same-day irrevocable wire
transfer of balances (allowing direct access to
the federal funds market), and access to the dis
count w indow.14
Meeting reserve requirements, however, has
not been closely related to use of the nation’s
central bank services. Nonpersonal time deposit
liabilities were one basis for setting the user fee
prior to December 1990, but those financial in
stalments are little different from some of the in
struments used in financing nonbanks, which are
not subject to the fee. In this sense, institutions
subject to the user fee obtained nothing that was
not available to institutions not subject to the fee.
Since December 1990, the relationship has been
closer. A depository institution’s corporate char
ter includes the right to issue transactions depos
its; money market mutual funds and credit card
services offer closely competing products that
limit banks’ ability to transfer the tax to holders
of transactions deposits. With the ability to issue
taxed deposits come associated rights to Federal
Reserve services, although there is no necessary
connection between the amount of central bank
services a bank uses and its tax payment.
■
13 These same tax estimates have been in an 8.5 percent to 10.5
percent range of after-tax bank profits since 1982 (using actual losses
and recoveries rather than provisions for loan losses as the relevant ex
pense item in calculating profit).
■
14 This view is made explicit in the suggestion that reserve re
quirements be based not on the level of deposits, but on activity in de
posit accounts (Jacoby [1963]). Mayer (1966) presents a different
argument: Reserve requirements are an excise tax on the im plicit return
to holders of non-interest-bearing deposits. He suggests that the tax is
a “second-best” way to avoid distorting resource allocation in a world
replete with sales and excise taxes on the explicit prices of other items.
This assumes, however, that the incidence of the tax is on depositors,
which need not be the case if good substitutes are available.
9
If reserve requirements are indeed an im
plicit user fee, they are for access only. With few
exceptions, explicit fees for Reserve Bank pay
ment services cover the full cost of their provi
sion. Stripping away these services, if the reserve
requirement tax is to be considered a user fee, it
must be a fee paid for the right to use a Federal
Reserve deposit account to settle transactions
and for access to the discount window as the
lender of last resort.
The tax rationale for reserve requirements is
weak. While the requirements have some of the
characteristics of a tax, they are neither a de
pendable and important source of revenue nor
a user fee that relates the quantity of services
used to the payment made.
III. The Monetary
Policy Rationale
for Reserve
Requirements
Monetary policy has the unique function of con
trolling the supply of “outside money." In the
United States, it is the Federal Reserve that
decides how much outside money to make
available to the private sector, in the form of cur
rency held by the nonbank public and banks’
holdings of vault cash and deposit balances at
Reserve Banks. These assets are created, for the
most part, by Federal Reserve open market pur
chases of U.S. government securities and by dis
count window lending.
Binding reserve requirements introduce an
artificial demand for outside money on the part
of banks. Two questions arise in looking for a
monetary policy rationale for requirements.1'’
One is whether they are necessary for monetary
control to function, and the other (irrespective of
necessity) is whether they improve monetary con
trol by reducing deviations from policy objectives.
Are Reserve
Requirements
Necessary for
Monetary Control?
Reserve requirements are not necessary for m on
etary control to function as long as, in their
absence, there is a demand for the outside
money the central bank supplies. With outside
money demanded for its own sake, control of
its supply provides the “anchor” to money,
credit, and prices that defines the role of mone
tary policy in the economy. For the foreseeable
future, the public can be expected to demand
currency and the banks to demand vault cash.
Managing the supply of one or the other, or the
combination of the two assets, should ensure
that monetary control can function.16
A more mundane question concerns tradi
tional monetary policy operating procedures
used in guiding open market operations and dis
count window lending. Might reserve require
ments be necessary because it would be
impossible to carry on monetary policy in these
familiar forms if vault cash were banks’ sole out
side money asset?
Here again the answer is no. Controlling the
supply of currency assets need not operate any
differently than monetary policy operates today.
Banks’ demand for outside money would con
sist exclusively of their demand for vault cash,
and banks’ Fed deposit accounts would retain
their utility for making and receiving payments,
including the payments involved in open mar
ket operations. The only difference would be
that the daily target balance of each bank at the
close of business would be zero, rather than
today’s positive amount related to a required
reserve. No bank would voluntarily hold depos
its that do not pay interest when it could earn
interest simply by selling the funds for immedi
ate delivery in the overnight market (unless the
overnight rate were zero).17
The trillion dollars or so of private dollar pay
ments settled directly or indirectly on the books
of the Federal Reserve Banks each day provide
no basis for banks to demand non-interest-
■
16 A classic discussion of this point may be found in Fama
(1980). Sargent and Wallace (1985) examine a related question:
whether and how the price level is determined if the monetary base bears
a market rate of interest. Fama’s discussion is the relevant one here,
where currency, including vault cash, does not carry explicit interest
and where monetary policy does not seem likely to target or to achieve
the deflation rate required to approximate a real, market rate of interest
on currency. See also the discussion of clearing balances In section IV.
■
■
15 The title and language of the Monetary Control Act of 1980 make
clear that reserve requirements were rationalized as a monetary policy device
at that time. Depository institutions were instructed to maintain reserves
"... as the Board may prescribe by regulation solely for the purpose of imple
menting monetary policy.” See Board of Governors of the Federal Reserve
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System (1988).
Federal Reserve Bank of St. Louis
17 This is the extreme case. It abstracts from any clearing balances
banks might want to maintain with the Fed in return for earnings credits
used to offset charges for priced services. Only about $3.2 billion of clear
ing balances were held in July 1991, which would earn about $180 m il
lion at a 5.75 percent funds rate, or roughly 20 percent of 1990 total fees
for priced services. It also Ignores the possibility of requiring clearing
balances with no (or wasted) earnings credits to reduce Reserve Bank risk
exposure through daylight and overnight overdrafts.
bearing deposit balances overnight.1S By defini
tion, all of these payments net to zero. O f
course, on any particular day some banks will
find themselves in a net credit position, receiv
ing more payments than they make, while
others will find themselves in an equal and off
setting net debit position. Banks with net credits
(or their customers) can lend the needed funds
to banks with net debits, with same-day delivery.
Payments do not net to zero for transactions
between the private sector and the Fed, the
Treasury, or any other institution able to operate
outside the private banking system because it
holds accounts directly with a Federal Reserve
Bank. However, as long as there is no monetary
policy reason to change the supply of outside
money, the Federal Reserve can be expected to
engage in defensive open market operations to
offset the net debit or credit created by payments
between the private banking system and these
other institutions. Inevitable errors in forecasting
reserve availability, however, will produce days
of oversupply, when banks are left holding
some unwanted reserve deposits, or of under
supply, when banks are forced to borrow from
the discount window to avoid overdrafts.19
Errors in reserve supply should be more
noticeable when the target is a zero aggregate
stock of reserves rather than a positive stock.
The federal funds rate and discount window
borrowing would be more volatile, both during
a day and day to day, unless the operating pro
cedure for implementing policy were made
more continuously rate sensitive, or market
forces developed new ways to smooth the rate.
Today, the need for reserve deposits to satisfy
reserve requirements provides a market basis
for arbitrage that smooths the funds rate in the
face of supply errors. If reserves are short in the
aggregate and the rate starts to rise relative to the
expected level, banks can lend by postponing
■
18 Banks could still initiate payments at the opening of business,
even with zero overnight balances, as long as Reserve Banks continued to
permit daylight overdrafts. If daylight overdrafts were prevented, zero over
night balances would preclude banks from initiating same-day payments
from their Reserve Bank accounts at the opening of business. However,
even in this case, banks would likely find it cheaper to alter the mechanisms
of clearing and settlement than to bear the opportunity cost of non-interestbearing overnight balances. All payments could be processed on private
clearing networks, with simultaneous net settlements at a common hour, or
with settlement in some medium other than Reserve Bank accounts. For a
discussion of the trade-offs among overnight Reserve Bank balances, day
light overdrafts, and private payments innovations, see Stevens (1991); for
a discussion of alternative settlement media, see Stevens (1978).
■
19 Occasional estimates of reserve supply errors can be found (Meek
and Levin [1981]; Dewald and Gibson [1967]). However, these are for aver
age levels over a maintenance period, not for the single days relevant to
defensive open market operations in the absence of reserve requirements.
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Federal Reserve Bank of St. Louis
the accumulation of required reserve deposits;
conversely, they can accelerate the accumulation
if reserves are oversupplied and the rate starts to
fall. The rate tends to spike or to plunge only at
the end of a day, when most potential counter
parties have closed, and on settlement day (the
last day of a maintenance period), when carryover
provides the only leeway for banks to postpone
or to accelerate reserve accumulation.
Every day would be a settlement day if there
were no reserve requirements and therefore lim
ited possibilities for arbitrage. Every bank would
want zero Fed deposits every night. An aggre
gate oversupply would lead borrowers away
from the discount w indow and, if that were not
sufficient to correct the oversupply, would drive
the rate immediately to zero. An aggregate
undersupply would drive the rate high enough
to lead banks to the discount window to avoid
overdrafts. It is unlikely that new market mecha
nisms would develop to smooth the rate, given
current institutional arrangements. (This issue is
discussed more fully in section IV.)
Policy actions (nondefensive open market
operations) would have the same immediate
effect as errors in reserve supply and might be
more difficult for the public to identify in the
context of wider daily volatility of the funds rate
and of borrowing. Persistence of the visible
effects of easing or restraining reserves would
eventually distinguish a policy move from the
transitory effect of one or more defensive errors.
Another likely difference is that, as policy re
straint intensified or relaxed, banks would seek
new ways to influence the public’s holdings of
currency. This would allow banks to escape
complete reliance on the discount window in
avoiding overdrafts and wasted non-interestbearing reserve deposit balances.
Do Reserve
Requirements
Improve Monetary
Control?
The essence of monetary control lies in supplying
the amount of outside money most likely to
achieve the policy objective. Although reserve re
quirements are unnecessary, they might improve
monetary control by ensuring a more predictable
relationship between a policy objective and the
policy instrument used in seeking that objective.
Investigating two dominant approaches to policy
implementation suggests that even though this
rationale cannot be ruled out altogether, it
is weak.
One approach to defining the objective/
instrument relationship in monetary policy
would rely on reserve targeting based on the
multiplier concept.20 Reserve requirements can
improve monetary control by making the re
serves multiplier more predictable. This can be
illustrated within a simple monetarist policy
framework. Suppose that 1) the ultimate policy
objective is a stable price level, 2) the most reli
able route to this objective is to maintain steady
growth of an intermediate target for the transac
tions deposits supplied by banks, and 3) those
deposits tend to be a multiple of vault cash,
where the predicted multiple is subject to a nor
mally distributed error. Without a reserve
requirement, banks will hold no Fed deposits,
and assuming no reserve supply errors, devia
tions from the predicted multiplier will reflect
variations in banks’ demand for vault cash rela
tive to their deposit liabilities.
Imposing a binding reserve requirement
under these circumstances will create an artifi
cial demand for reserve deposits and will con
strain variations in the multiplier. Variations in
demand for vault cash relative to deposit liabil
ities will not affect the demand for reserve
assets relative to deposit liabilities, which
remains a constant, required fraction of bank
deposits. All else equal, reserve requirements
might improve monetary control by reducing
deviations of money from the policy target guid
ing the supply of reserve assets.
Two matters diminish the persuasiveness of
this rationale. One is that, in the absence of re
serve requirements, the “noise” introduced into
the multiplier by variations in the demand for
vault cash is likely to be short run around a stable
trend value. Introducing a reserve requirement
might produce a multiplier that is more predict
able in the short term, but at the cost of introduc
ing longer-run changes in the trend value as
banks and their competitors devise substitutes
for reservable deposits to avoid the reserve re
quirement tax.
The other matter is that the Federal Reserve
has never used a consistent multiplier proce
dure.21 Unless the System were expected to
adopt such an approach in the future, improving
■
20 A fu 11treatment of the multiplier approach to po Iicy control of
the monetary aggregates can be found in Rasche and Johannes (1987).
21 See Goodfriend and Hargraves (1983). Perhaps the closest
approximation to the multiplier model was the procedure for controlling
M1 used from October 1979 through late 1982. Reserve paths guided
open market operations, but the paths were adjusted at and between Fed
eral Open Market Committee (FOMC) meetings to reflect independent
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judgments about the appropriate federal funds-rate level.
monetary control by increasing the short-run
predictability of a reserves multiplier would rep
resent an irrelevant monetary policy rationale
for reserve requirements.22
Interest-rate targeting is the alternative ap
proach to monetary policy implementation. As
long as the intended interest rate is not set in a
vacuum but in the context of a reliable feedback
mechanism for controlling a monetary aggregate,
nominal GNP, or the price level, the procedure
amounts to an indirect method of reserve target
ing. The target amount of reserves is the quantity
that must actually be supplied in order to main
tain the intended interest-rate level for a short
period within the feedback process.
Interest-rate targeting in the absence of
reserve requirements should not involve the
same short-mn noise associated with the reserves
multiplier approach. Open market operations
that seek to stabilize a money market interest
rate would tend to accommodate unpredictable
short-run variations in the demand for vault cash
relative to deposits.23
In sum, improving monetary control provides
scant rationale for reserve requirements. Only if
the Federal Reserve were to adopt a reserves tar
geting approach to policy implementation, con
trary to long-standing practice, could reserve
requirements be expected to make the effects of
policy actions more predictable in the short run.
IV. The Liquidity
Rationale
for Reserve
Requirements
A third rationale sometimes suggested for re
serve requirements is that they serve as a regula
tory measure to ensure that banks, individually
or in the aggregate, will be able to meet demands
■
22 Increased predictability was a major goal of the wholesale reform
of reserve requirements recommended by members of the Committee on
Bank Reserves of the Federal Reserve System in 1931. With hindsight, their
rationale was no more relevant then— after the late-1920s explosion of
debits/deposit accounts (to which they pointed) and in the midst of the
1929-1933 collapse of the banking system (to which they appeared oblivi
ous)— than now. The Committee apparently had no conception of using
defensive open market operations to offset variations in a multiplier. Unfor
tunately, theirs was the prevailing view within the System after the death of
Benjamin Strong in 1928 (see Friedman and Schwartz [1963], especially pp.
407-19). Instead, they recommended legislation (never enacted) to make the
required reserve ratio vary with the debits/deposits multiplier.
■
Federal Reserve Bank of St. Louis
■
23 Both reserves and interest-rate targeting are susceptible to the
daily implementation errors discussed earlier. Inaccurate estimates of
market factors affecting the stock of reserves will produce quantity errors;
inaccurate estimates of the needed size or market interpretation of open
market operations will produce interest-rate errors.
for payment without delay. Regulators have twin
concerns of ensuring banks’ solvency (capital
adequacy) and banks’ liquidity (cash adequacy).
The concept of requiring banks to maintain at
least a minimum capital/asset ratio to ensure sol
vency' remains in the bedrock of bank supervi
sion; the concept of requiring banks to maintain
at least a m inim um cash/deposit ratio to ensure
liquidity, on the other hand, has long been dis
counted, but deserves some reconsideration.24
Method of
Enforcement
Reserve requirements cannot provide a mean
ingful source of liquidity for an individual bank
or for the banking system as long as the require
ment is enforced continuously. After all, if a
bank were required to keep a 10 percent reserve
every day, then it would have only 10 cents avail
able to meet each dollar of deposit withdrawn. A
reserve regulation that is continuously enforced
can guarantee adequate liquidity only with a 100
percent requirement.
Reserve requirements can provide a meaning
ful source of liquidity as long as they are not en
forced continuously. The entire pool of required
balances can be used to cover an immediate cash
drain and can then be replenished either from
asset sales or borrowing or from a return flow of
deposits, as time allows. Early proponents of a
reserve requirement recognized the inadequacy
of continuous enforcement. Their intention was
not to prevent a bank from using all of its cash as
a source of liquidity when necessary, but to have
each bank husband cash in nonnal times.
Reserve requirements under the National
Bank Act (1863), for example, were not en
forced daily. A bank whose reserve fell below
the requirement wras prohibited both from ex
panding its liabilities through new lending and
from paying dividends. W hen aware of defi
cient reserves, the Comptroller of the Currency
was empowered, but not required, to give a
bank 30 days’ notice to come into compliance.
24 As long ago as 1931, the Committee on Bank Reserves of the
Federal Reserve System (1931, p. 5) took the position that it was no longer
the primary function of legal reserve requirements to ensure or to preserve
the liquidity of individual member banks. In 1957, the Economic Policy
Commission of the American Bankers Association (1957, p. 14) concluded
that “ ... those who cling to the old liquidity approach to reserve require
ments will therefore be in disagreement with many of the Commission’s
conclusions. They are also likely to find themselves in disagreement
among themselves, because the liquidity approach is not only basically
illogical, but inevitably leads into a maze of complicated side issues on
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which no clear-cut answers are possible.”
Failing compliance, the Comptroller was then
authorized, but not required, to close the bank.25
The same prohibition on new lending and
dividend payments appeared in the original Fed
eral Reserve Act. More stringent enforcement
developed after 1913, so that by 1935, member
banks had little scope to use required reserve
deposits even as a short-run source of liquidity.
They were expected to maintain required
reserve deposits (vault cash was not eligible) for
semiweekly, weekly, or semimonthly averaging
periods, depending on the bank’s size and loca
tion (see Board of Governors of the Federal
Reserve System [1935], p. 837). Deficiencies
were penalized at a rate 2 percent above the dis
count rate, and while same-day wire service
was available for transfers of reserve deposits,
daylight overdrafts were not permitted.
After 1935, the scope for relying on required
reserves as a short-run source of liquidity grad
ually increased. In the mid-1950s, averaging had
broadened to one- or two-week periods, and the
practice of allowing a 2 percent carryover was in
place (see American Bankers Association [19571,
p. 9). Since 1984, averaging has been permitted
within two-week periods for all banks. This en
forcement mechanism still prevents banks from
relying on required reserves as a source of liquid
ity for longer than a portion of a reserve mainte
nance period or, with carryover, for two adjacent
periods. Sustained needs for liquidity require
secondary reserves and access to the money and
interbank-loan markets or, if all else fails, to the
discount window. However, within a reserve
maintenance period, reserve requirements can
enhance banks’ liquidity by guaranteeing a pool
of deposits from which to fund imbalances, such
as those arising from clearing and settlement of
checks and electronic payments.
Reserve requirements do not provide this
source of liquidity for banks that use only vault
cash to cover their entire required reserve posi
tion. For institutions in or near this unbound
condition, the daily target for a reserve deposit
account must be zero; averaging from day to
day is not feasible because overnight overdrafts
of Fed deposit accounts are penalized.26 This is
■
Federal Reserve Bank of St. Louis
■
25 Rodkey (1934) provides a detailed discussion of reserve re
quirements under the National Bank Act.
■
26 Overnight overdrafts are costly in that, in addition to the cost of fi
nancing a “makeup" balance on a subsequent day, the overdraft is penal
ized at a rate 2 percent above the effective federal funds rate on the day the
overdraft occurred. The ability to run significant daylight overdrafts in Fed
eral Reserve deposit accounts allows banks to cover payments during a day
without the need for positive reserve deposit balances at the beginning and
end of the day. For a discussion of daylight overdrafts, see Stevens (1991 ).
13
one reason why banks enter into clearing bal
ance agreements with their Reserve Banks. By
targeting a positive clearing balance, they
reduce the chances that unexpected events,
especially those late in the day, will result in
costly overnight overdrafts or wasted earnings
opportunities. Clearing accounts make sense only
for institutions that can use the earnings credits
from clearing balances. Others may prefer to
operate through a correspondent bank rather
than through targeting a zero balance in their
reserve deposit accounts.
Banks that do use reserve deposits to meet
reserve requirements gain liquidity within the im
mediate confines of a reserve averaging period.
Unexpected outflows on a given day can be
funded by drawing the reserve deposit balance
down as low as zero, as long as this action is off
set by holding a large enough balance on future
days to maintain the required average balance
during a reserve maintenance period. Similarly,
unexpected inflows of funds on a particular day
do not represent a wasted earnings opportunity
if offset by a smaller balance on future days.27
The lengthening of reserve averaging periods
over the past 50 years has increased the oppor
tunity for banks to use reserve deposits for shortrun liquidity management. However, the ex
panded opportunity has not been fully realized
for three reasons. First, as noted earlier, required
reserves have grown only one-third as rapidly as
the banking system (table 3). Second, reserve
deposits have declined from 100 percent to 45
percent of required reserves since 1959, when
banks were first permitted to satisfy reserve re
quirements with vault cash. Third, the value of
transactions and, presumably, the potential need
for liquidity to cover unexpected imbalances be
tween inflows and outflows of funds have grown
far more rapidly than reserve deposits. For exam
ple, while banks’ reserve deposit balances grew
at a 1.3 percent annual rate between 1952 and
1990, the dollar value of payments made from
banks’ Federal Reserve accounts grew at a 20
percent annual rate.
Development of active same-day reserve
account management techniques has supple
mented reserve deposit balances in the handling
of day-to-day liquidity needs for many banks.
■
27 Some examples may be useful: A bank required to hold an
average balance of $100 million can let the balance drop to zero on the
first day and then hold $107.7 m illion on the remaining 13 days. Or,
having held $100 m illion on average over the first seven days, it can let
the balance drop to zero on the eighth day and then hold $116.7 million
on the remaining six days. Even on the last day, taking carryover into con
sideration, a bank that has held $100 m illion on average over the first 13
days and has met 55 percent of its requirement with vault cash could let
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its balance drop to $38 million on the last day (see footnote 4).
Federal Reserve Bank of St. Louis
Sophisticated computerized systems track move
ments in reserve deposit accounts during the
course of a day; as needs become apparent,
same-day transactions are used to fund poten
tial deficits or to lay off surpluses in the money
and interbank markets. The extent to which
modem reserve requirements have a short-run
liquidity rationale depends on the size of the
pool of reserve deposits (for an individual bank
and in the aggregate) relative to potential liquid
ity needs, which are heavily influenced by the
availability of alternative sources of liquidity.
A Redundant
Assurance of
Liquidity
Before the Federal Reserve System was estab
lished in 1913, the hallmark of adequate liquid
ity in the banking system was an increase in the
ratio of currency to bank deposits without a
suspension of specie payments, whether in
response to a seasonal increase in currency de
mand or an incipient banking panic. Typically,
this was made possible by m nning down the
cash reserves of banks in Reserve cities, as other
banks drew on them. Augmenting the aggregate
stock of cash by tapping Treasury and foreign
holdings of specie tended to be inadequate.28
Since 1913, however, Reserve Banks have
been able to augment the aggregate stock of
cash in response to increased demand. This
provides a choice of regulatory mix in manag
ing short-run liquidity, both in the aggregate
and at individual banks. Reserve requirements
can be used to ensure a pool of cash in advance
of day-to-day potential needs. Reserve averag
ing and carryover at individual banks can then
allow this pool to be redistributed among banks
through transactions in the federal funds market
and other markets for instruments with sameday payment. Alternatively, the central bank
can simply add and absorb cash on a daily basis
in response to actual needs. Defensive open
market operations and discount w indow lend
ing can tailor the size and the distribution of the
pool to the liquidity needs of the day.
Today, therefore, a liquidity rationale for
reserve requirements would need a supporting
demonstration of some public benefit connected
with retaining a market cash-in-advance facility
as an alternative or a supplement to government
credit-on-demand in the liquidity mechanism.
■
28 A recent review of historical episodes of liquidity strains can be
found in Smith (1991).
These public benefits might lie in damping vol
atility of the federal funds rate and in monitor
ing credit quality.
As monetary policy and Reserve Bank opera
tions are now structured, reserve requirements
have the effect of maintaining a reasonably
steady rate signal that is the basic source of
short-run information about policy. In the ab
sence of reserve requirements, the federal funds
rate would be more volatile from day to day
than it is now, all else equal."9 The nub of the
problem is simply that, without the opportunity
for arbitrage created by reserve averaging as
sociated with reserve requirements, every bank
would want a zero balance overnight (as long
as the overnight funds rate were positive) be
cause Fed deposits do not earn interest. Devia
tions of the daily aggregate supply of Fed
deposits from zero, whether from forecasting er
rors in carrying out defensive open market
operations or from deliberate policy adjust
ments, would cause the rate to spike or to
plunge (to the extent that banks were reluctant
to use the discount window), because no inter
day arbitrage would be possible. With greater
rate volatility, market participants might have
difficulty discerning the funds-rate level in
tended by policymakers. A more volatile rate
may be undesirable if it befogs market percep
tions of monetary policy intentions.
O f course, reserve requirements are not the
only mechanism for damping funds-rate volatil
ity, and the funds rate is not the only vehicle for
conveying monetary policy information. None
theless, it is worth considering whether, or w'hat
sort of, a rate-smoothing mechanism might
develop in the absence of reserve requirements.
• Banks would be unlikely to hold excess
reserves in place of today’s required reserves.
They would need to foresee profits from fi
nancing the inventory of non-interest-bearing
deposits upon which they would draw for
occassional lending when the rate spiked. This
would be possible only if the average of ex
pected future overnight funds rates were higher
than the permanent cost of financing the inven
tory. That is, the likelihood of aggregate reserve
shortfalls in defensive open market operations
and policy adjustments would have to exceed
the likelihood of aggregate reserve surpluses.
There seems to be no reason to expect such
asymmetry/
• For several reasons, clearing balances
are an uncertain basis for market arbitrage to
smooth the funds rate, even though they pay
■ 29 Volatility during the course of a day might also be greater,
depending on rules for daylight overdrafts.
a market rate of interest as currently admin
istered (see section I and footnote 5). First,
because clearing balances are optional, they
may be insufficient to support the amount of
arbitrage required to smooth the funds rate.
Banks now choose this method to pay for
only about 20 percent of the $900 million of
Reserve Banks’ priced services (by holding
balances of less than $4 billion). Second, even
if antitrust considerations did not preclude
making clearing balances the mandatory
mode of payment, the volume of balances
might be insufficient, being a function of reg
ulatory and competitive forces determining
the demand for Reserve Bank services, as well
as of the level of interest rates. For example,
the entire $870 million of priced services in
1990 would have required balances of $15 bil
lion if the earnings rate were at the mid-1991
5.75 percent level, but only $10.7 billion at
the 8.1 percent average funds rate in 1990.
Finally, as this example suggests, and as Sar
gent and Wallace (1985) have pointed out,
paying a market rate of interest on reserves
may introduce an indeterminacy into the
economy that renders moot the whole con
cern for the funds rate as a policy signal. If
the only reason to hold clearing balances is
to pay for a fixed value of priced services,
then there could be no excess supply or
demand for balances because the funds rate
would vary inversely with balances to main
tain the fixed-dollar value of their yield.
• The discount window is the most likely
source of rate smoothing in the absence of in
terday arbitrage. Aggregate under- and over
supplies of Fed deposits would put pressure
on the funds rate, but the degree to which
that pressure actually pushed the funds rate
up and dowrn would depend on how readily
banks approached the window' and on how
readily Reserve Banks would lend.
• If a clear indication of the policy rate
were desirable for policy information pur
poses, more direct methods could be used.
FOMC policy decisions could be announced
immediately, rather than after the next regu
larly scheduled meeting. A more radical
change would be to have the Desk make
both reserve balances and securities avail
able continuously throughout each day, en
gaging in repurchase and matched-sale
agreements in Treasury securities on demand
at announced prices set by the FOMC.
A smoothed policy rate is not a necessity.
However, the potential for funds-rate volatility
is simply a symptom of deviations between
■ 30 In Canada, banks are said to hold excess reserves as protection
against unexpected net debits, but the Canadian discount rate is market re
lated, with penalties for repeated borrowing (Freedman and Dingle [1986]).
actual supply and zero demand for holding Fed
deposits in the absence of the liquidity pro
vided by reserve requirements. Another matter
to be considered is that relying exclusively on
the central bank to provide day-to-day liquidity
would eliminate the role of the funds market in
monitoring the credit quality of banks.
A more volatile funds rate would reflect the
absence of market supply and demand for over
night holdings of Reserve Bank deposits. When
open market operations were completed for a
day, the discount window would be the only
liquidity mechanism available for adjusting the
aggregate supply of Fed deposits. Borrowing at
the window would be the sole way for banks
that were left short to avoid overdrafts caused
by inevitable forecasting errors in the carrying
out of defensive open market operations, be
cause no pool of reserve deposits would be
available to lend; repaying discount window
loans would be the only way to avoid the
wasted earnings opportunity of holding a noninterest-bearing overnight deposit. Under these
circumstances, banks might come to view ac
cess to the window as a right, not a privilege,
and to borrow or repay whenever a high or low
funds rate suggested that the Desk’s injection or
withdrawal of Fed deposits had failed to accom
modate settlement of the day’s payments.
Widespread and continuous reliance on the
discount window has a by-product: It supplants
market judgments about creditworthiness with
regulatory judgments. If the deposit insurance
system does not guarantee repayment for all of
a bank’s creditors, a benefit of a liquidity mecha
nism that relies on a market-financed advance
pool of cash is the credit scrutiny of overnight
borrowers by overnight lenders. O f course, mon
itoring would continue in markets for other
forms of bank liabilities even if banks were to be
come more heavily dependent on the discount
window for overnight financing. Nonetheless,
the diminished importance of the overnight mar
ket for unsecured borrowing, coupled with
heightened assurance of official lending, should
increase the influence of regulatory opinion and
reduce the influence of market evaluations in
the short-run management of banks. Moreover,
Reserve Banks should then be expected to assert
their regulatory judgment as providers of sub
stantial amounts of unsecured daylight overdraft
credit, because reserve deposits would no longer
provide a buffer between them and general
creditor status in the event of a bank failure.
In brief, reserve requirements have a shortrun liquidity rationale because banks have no
other incentive to hold Fed deposits that do not
bear interest. Lacking this artificial demand for
cash, both accidental and policy-intended devia
tions of the stock of Fed deposits from zero
each day might impart undesirable volatility to
the funds rate. In any case, the burden of meet
ing the banking system’s liquidity needs would
fall heavily on credit decisions made at the dis
count window, reducing the role of market judg
ments about credit risk.
V. Conclusion
Rationalizing reserve requirements is not easy.
They have the aura of a tax, but revenue does
not seem to be their purpose. Avoidance erodes
the tax base, and regulatory efforts to avoid
avoidance have had the effect of reducing the
tax rate over time, so that reserve requirements
now yield less than half of 1 percent of Treasury
revenue. The requirements act as a license fee,
entitling some depository institutions to issue
reservable transactions accounts and to main
tain an account at, buy the services of, and bor
row from the Federal Reserve Banks. The
question at issue is whether there is a compel
ling rationale for maintaining the burden of a
license fee in the form of reserve requirements.
Monetary policy implementation has been the
statutory rationale for reserve requirements since
1980, but policy implementation would be little
affected by their elimination. With the interestrate targeting approach that has been typical of
Federal Reserve policy implementation, the ab
sence of reserve requirements could make the
federal funds rate more volatile in the very short
mn, perhaps reducing its value as an indicator of
policy intentions. However, changes in policy
techniques could offset this problem. If the alter
native reserve targeting approach to policy im
plementation were ever adopted, absence of
reserve requirements could make reserve targets
less predictable, but only in the very short run.
Reserve requirements can have a liquidity
rationale, contrary to traditional assertions that
have overlooked reserve averaging provisions
as the basis for interday arbitrage in the market
for Reserve Bank deposits. A liquidity rationale,
however, is only as strong as the preference for
having private markets rather than the Federal
Reserve manage the supply and distribution of
outside money each day. This preference may
be reinforced by a desire for greater reliance on
the federal funds rate than on the discount rate
as the dominant policy instrument, and for
greater reliance on FOMC guidance of the fed
eral funds rate than on Board of Governors’
control of the discount rate in managing mone
tary policy in the short run.
Experience with reserve requirements sug
gests that their rationale is ultimately irrelevant,
because they are an unsustainable regulatory
intrusion in competitive markets. Repeated mar
ket innovations aimed at avoidance, and regula
tory relaxation to avoid avoidance, have allowed
required reserves to grow at only one-third the
rate of growth of the banking system since 1952.
Moreover, reserve deposits have been declining
as a share of required reserves, with an increas
ing number of banks satisfying the requirement
through voluntary holdings of vault cash. If the
trend of the past 30 years continues, reserve
deposits will amount to only 10 percent of re
quired reserves within the next 30 years.
Preserving an effective system of reserve
requirements will be difficult if built-in incen
tives for avoidance and voluntary holdings of
vault cash continue to reduce both their burden
and their effects. But if reserve requirements
have no compelling rationale, why not elimi
nate them?
Appendix
Estimates plotted in figure 1 are based on the
assumption that required reserves finance a por
tion of Reserve Banks’ earning assets. Required
reserves must be apportioned between an amount
that would be held anyway and an amount held
solely because of the requirement. Earning assets
include Treasury and agency securities, loans to
depository institutions, assets denominated in for
eign currencies, and other loans. This assumes that
all noneaming assets (for example, gold certifi
cates, Special Drawing Rights, and buildings) are
financed by all other liabilities and capital (for
example, clearing balances, other deposits, excess
reserves, surplus vault cash, currency, capital
stock, and surplus).
Because all vault cash applied to required
reserves is excluded, the estimates plotted here
may be understated after 1959, when vault cash
became eligible to satisfy reserve requirements.
Using reserve deposits alone ignores the possi
bility that some banks are induced to hold addi
tional vault cash when the opportunity cost of
these funds is simply the cost of holding a
smaller deposit balance at the Fed. An estimate
based on required reserves including applied
vault cash would nearly double the tax attributed
to reserve requirements, but would be over
stated: The erroneous implicit assumption would
be that banks would hold no vault cash at all
were it not for reserve requirements. An inter
mediate method suggests that the understated
estimates involve less error than choosing to
overstate. If banks had maintained the same
proportion of vault cash to reserve deposits
after 1959 as they did in that year, the estimated
tax attributable to reserve requirements would
have been 16.5 percent higher in 1989, and the
contribution of required reserves to Treasury
revenue would have been 0.05 percentage
point higher.
The intentional understatement is offset by
some independent overstatements. One arises
from ignoring the possibility that holdings of
clearing balances would be larger in the absence
of reserve requirements (see section IV). Reserve
Banks’ fee income would then be smaller, offset
by larger interest income, if banks did not change
the quantity of services used. However, the
quantity would be unchanged only if the interest
income that banks forgo when holding a clearing
balance were no higher (per unit of service used)
than fees plus the value of the service a clearing
balance provides in avoiding overdrafts and
wasted reserves. This value would be created
for some banks by the elimination of reserve
requirements, so that clearing balances would
be expected to increase.
Another overstatement arises because
data limitations make it convenient to exclude
from earning assets both foreign-currencydenominated assets (for example, those
acquired through dollar-support intervention in
the foreign exchange market) and other loans
(for instance, those made to the Federal
Deposit Insurance Corporation when it assumes
a failed bank’s debt to the discount window).
The estimates presented here differ from re
lated estimates by Barro (1982) and Goodfriend
and Hargraves (1983) in that they include only
the Treasury revenue attributable to required
reserve deposits; the two earlier estimates deal
with Treasury revenue attributable to all outside
money issued by the Federal Reserve.
References
American Bankers Association, Economic Policy
Commission. Member Bank Reserve Require
ments. New York, 1957.
Barro, Robert J. “Measuring the Fed’s Revenue
from Money Creation,” National Bureau of
Economic Research, Working Paper No. 883,
April 1982.
Board of Governors of the Federal Reserve Sys
tem. Federal Reserve Bulletin, vol. 21, no. 12
(December 1935), p. 837.
______ . A n n u a l Report, 1970. Washington,
D.C.: Board of Governors, 1971.
______ . Federal Reserve Act a n d Other Statu
tory Provisions Affecting the Federal Reserve
System, Washington, D.C.: Board of Gover
nors, August 1988, pp. 43-44.
______ . Federal Reserve Bulletin, vol. 76, no.
12 (December 1990), p. A8.
Committee on Bank Reserves of the Federal Re
serve System. Member Bank. Reserves. Wash
ington, D.C.: U.S. Government Printing
Office, 1931.
Meek, Paul, and Fred J. Levin. “Implementing the
New Operating Procedures: The View from
the Trading Desk,” in New Monetary) Control
Procedures. Washington, D.C.: Board of
Governors of the Federal Reserve System,
Staff Study, 1981.
Meulendyke, Ann-Marie. U.S. Monetary Policy
a n d F in an cial Markets. New York: Federal
Reserve Bank of New York, 1989.
Partlan, John C., Kausar Hamdani, and Kathleen
M. Camilli. “Reserves Forecasting for Open
Market Operations,” Federal Reserve Bank of
New York, Quarterly Review, vol. 11, no. 1
(Spring 1986), pp. 19-33.
Rasche, Robert H., and James M. Johannes. Con
trolling the Growth o f Monetary Aggregates.
Boston: Kluwer Academic Publishers, 1987.
Dewald, William G., and William E. Gibson.
“Sources of Variation in Member Bank Re
serves,” Review of Economics a n d Statistics,
vol. 49, no. 2 (May 1967), pp. 143-50.
Rodkey, Robert G. Legal Reserves in Am erican
Banking. Ann Arbor: University of Michigan
Press, 1934.
Fama, Eugene F. “Banking in the Theory of
Finance, "Jo u rn a l o f Monetary Economics,
vol. 6(1980), pp. 39-57.
Sargent, Thomas, and Neil Wallace. “Interest on
Reserves "Jo u rn a l o f Monetary Economics,
vol. 15, no. 3 (May 1985), pp. 279-90.
Freedman, C., andJ.F. Dingle. “Monetary Policy
Implementation in Canada: Traditional Stmcture and Recent Developments,” in Changes
in Money-Market Instruments a n d Proce
dures: Objectives an d Im plications. Basle,
Switzerland: Bank for International Settle
ments, March 1986.
Smith, Bruce D. “Bank Panics, Suspensions, and
Geography: Some Notes on the ‘Contagion
of Fear’ in Banking,” Economic Inquiry, vol.
24, no. 2 (April 1991), pp. 230-48.
Friedman, Milton, and Anna Jacobson Schwartz.
A Monetary History o f the United States:
1867-1960. Princeton, N.J.: Princeton Uni
versity Press, 1963.
Goodfriend, Marvin, and Monica Hargraves. “A
Historical Assessment of the Rationales and
Functions of Reserve Requirements,” Federal
Reserve Bank of Richmond, Economic Re
view, vol. 69, no. 2 (March/April 1983), pp.
3 - 21 .
Jacoby, Neil. “The Stmcture and Use of Variable
Bank Reserve Requirements,” in Deane Car
son, ed., B anking a n d Monetary Studies.
Homewood, 111.: Richard D. Irwin, Inc., 1963.
Mayer, Thomas. “Interest Payments on Required
Reserve Balances,”Jo u rn a l o f Finance, vol.
21, no. 1 (March 1966), pp. 116- 18.
Stevens, E.J. “EFT, Member Bank Reserves and
Monetary Policy,”Jo u rn a l o f Contemporary
Business, vol. 7, no. 2 (Spring 1978), pp.
167-85.
______ . “Pricing Daylight Overdrafts,” in
George Kaufman, ed.. Research in F in an cial
Services. Greenwich, Conn.: JAI Press, 1991.
______ . “The Origins of Reserve Requirements in
the United States,” Federal Reserve Bank of
Cleveland, Working Paper (forthcoming).
Volcker, Paul A. “Statement before the Commit
tee on Banking, Housing, and Urban Affairs,
U.S. Senate, February 4, 1980,” Federal
Reserve Bulletin, vol. 66, no. 2 (February
1980), pp. 143-48.
Government Consumption,
Taxation, and Economic Activity
by Charles T. Carlstrom and Jagadeesh Gokhale
Introduction
The size of government consumption relative to
gross national product (GNP) has grown steadily
in Europe and North America over most of the
post-World War II period. In real temis, govern
ment expenditure in the United States has grown
at nearly 4 percent annually over the last four
and a half decades. As a percentage of GNP, it
rose from approximately 13-7 percent in 1946 to
22.1 percent in 1989.1
Until recently, most of the increases in U.S. gov
ernment spending have been financed through
higher taxation (see Meltzer and Richard [1981]).
What are the likely effects of such increases on
output?2 How would they differ if deficit financ
ing were used? Our analysis seeks answers to
these questions.
■
1 It should be noted that growth in the share of government expendi
ture on goods and services in the post-World War II period is mostly due to
growth in state and local expenditures. Federal spending as a share of GNP
fell in the 1970s, from 10 percent to 8 percent, and remained around 8 per
cent in the 1980s. Our analysis deals with total federal, state, and local gov
ernment expenditures on purchases of goods and services.
■ 2 We abstract from the question of whether permanent increases in
government expenditure per se are good for the economy.
Charles t. caristrom and
Jagadeesh Gokhale are economists
at the Federal Reserve Bank of
Cleveland. The authors thank Alan
Auerbach and Laurence Kotlikoff
for use of their simulation model.
They also thank David Altig,
Randall Eberts, William Gavin,
Sharon Parrott, and John Sturrock
for helpful comments.
Although most increases in government expen
diture over the past 45 years have been perma
nent, there have been a few notable exceptions
when government consumption rose temporarily
and then came back down to its trend level. These
periods have typically been war years, with the
World War II and Korean War eras being the most
obvious examples. The effects on output of financ
ing such temporary increases depend on whether
deficit financing is used, and these effects can be
quite different from those arising as a result of a
permanent expansion in government spending.
It should be mentioned that increased levels of
government spending can affect output directly by
altering the conditions of production through the
provision of infrastructural inputs. We do not
analyze the effects of larger government expendi
ture on output due to improved productivity of
inputs.3 We also do not aim to provide an explana
tion for the growth in government expenditure, or
to determine the optimal size of government.4
■
3 Aschauer (1989) estimates that the public investment component
of government expenditure has a positive and significant effect on the
level of output.
■
4 Meltzer and Richard (1981) develop a theory of the size of
government.
19
Neither do we try to explain any particular epi
sode in the United States.
Instead, our analysis is limited to tracing the
causal links among higher government expendi
ture, tax policy, and the level of output. The
reason is that increases in government spending
— and the timing of taxation enacted to finance
them — affect private incentives to work and
save over time. Consequently, such increases
affect the l^vel of output, interest rates, and
other economic variables. We also present some
illustrative simulations of the effects of perma
nent and temporary increases in expenditure
with and without deficit financing in a stylized
model of the economy.
To conduct the analysis, we use the overlapping
generations model developed by Auerbach and
Kotlikoff (A-K) (1987), which is calibrated with
parameter estimates from various studies based on
U.S. data.'1 We present a brief description of this
model in section I. Section II discusses the effects of
permanent increases in government expenditure.
Our simulations show that with no deficit financing,
a permanent rise in government consumption leads
to lower long-run output. For an increase in expen
diture of the magnitude of 4 percent per year, out
put declines by about 2 percent. With deficit financ
ing, output is higher in the short run, but declines
considerably in the long am. Section III deals with
the case of temporary increases. There are no longmn effects on output if balanced-budget financing
is used. However, short-ain effects on output are
sensitive to financing considerations. Section IV
concludes the paper.
I. The A-K Model
Most studies that have investigated the effects of
permanent and temporary changes in govern
ment expenditure have used an infinite-horizon
representative-agent framework. All agents are
assumed to be identical and to live forever.
These models typically assume that government
revenues are raised by lump-sum taxes that are
nondistortionary.6 These two assumptions imply
that the Ricardian equivalence theorem (RET) will
be true. This theorem states that the timing of
taxes will not matter for private consumption and
leisure decisions, because if government expendi
tures are financed through a deficit rather than by
■
5 See Wynne (1990) for an example of a representative-agent model
used to explain output and interest-rate changes in the United States arising
from increased government expenditure during World War II.
6 See, for example, Baxter and King (1990) and Aiyagari, Chrishttp://fraser.stlouisfed.org/
tiano, and Eichenbaum (1990).
Federal Reserve Bank of St. Louis
■
current taxes, the infinitely lived agents will
anticipate the future tax liabilities implied by the
requirement that the government’s intertem
poral budget must be balanced. Both output and
interest rates will be the same under either of
these two financing arrangements.
Under the representative-agent framework,
both permanent and temporary increases in gov
ernment expenditure boost output. A permanent
rise in government spending increases output be
cause higher (lump-sum) taxes have a negative
income effect that leads individuals to reduce
leisure and thus to work harder. Temporary in
creases also lead to higher interest rates and out
put. If taxes are raised concurrently with greater
government expenditure, they will be higher
tcxlay than in the future. Individuals’ attempts to
smooth consumption over time will induce them
to save less (or borrow more), causing interest
rates to rise. The higher interest rates will induce
greater work effort today because of the inter
temporal substitution effect.
In this paper, we adopt the A-K overlapping
generations model, where individuals in each gen
eration are concerned about their own welfare but
not about that of their offspring. This implies that
RET will not hold, because if taxes are increased
in the future, rather than contemporaneously,
some generations will escape the burden of higher
taxation. Thus, deficit-financed increases in gov
ernment expenditure will have different effects
compared to those arising from balanced-budget
increases. Empirical studies have not yet resolved
the debate about the validity of RET.
We also assume that government revenue is
generated by income taxation rather than
through lump-sum taxation. Unlike lump-sum
taxes, income taxes distort the labor—leisure
choice by driving a wedge between before- and
after-tax wage rates. Income taxes also distort
the consumption-saving decision by introduc
ing a gap between before- and after-tax interest
rates. Using income taxation rather than lump
sum taxation is largely responsible for the dif
ference in our results compared to those
derived from representative-agent models.
The A-K model incorporates perfect foresight
on the part of individuals except with regard to the
policy change, which is assumed to be unantici
pated. The alternative would be to use a model
with “myopia,” where individuals behave as if
economic conditions did not change from period
to period. Under the latter assumption, however,
it would be difficult to separate the effects of
■ 7 A critical evaluation of the theory and evidence on RET is con
tained in Bernheim (1987).
20
irrational household behavior from those of the
policy change itself. Although perfect foresight
is an extreme assumption, it provides a useful
benchmark for analysis.
In the A-K model, each cohort is identical,
except for size differences due to population
growth. Each generation is 1 + n times larger
than its predecessor, and each has an economic
life span of 55 years. The annual utility function
is assumed to take a constant elasticity of sub
stitution form given by
(4 )
i
(1)
ut = [ct (1-p ) + a lt (1-p >] (1 p' + v (G t ) .
Here, the parameter p is the within-period elas
ticity of substitution between consumption and
leisure, and is the intensity of preference for
leisure relative to consumption. Government
consumption in period t is represented by Gt ,
which is exogenous and enters separably in the
utility function. This implies that the size of
government consumption does not affect the
marginal utilities of private consumption and
leisure. Some evidence suggests that this assump
tion may not be completely justified.8 If we as
sume that government expenditures are perfect
substitutes for private consumption and that
taxes are lump-sum, then increases in govern
ment expenditure, whether pemianent or tem
porary, will have no effect on either output or
interest rates. Thus, the assumption that govern
ment expenditure enters separably in the utility
function will overstate the effect on output.
Individuals choose consumption and leisure
for each period to maximize lifetime utility
given by
55
(2)
U = -- i —
X
d + 8 ) - ('- 1)
d - v ) ->
where t indicates cohort age. The parameter y
is the intertemporal elasticity of substitution, and
8 is the pure rate of time preference.
Households maximize utility (equation [2])
subject to a period-by-period budget constraint.
The time 5 budget constraint for individuals
aged t is given by
(3 )
a s,t -
as -
1, / -
i^ 1 +
r s- i 1 -
xs
Here, rs refers to the before-tax rate of interest, Ts.
refers to the income tax rate applied in period s,
and iist refers to the nonhuman wealth held in
period 5 by an individual aged t. The pre-tax
wage rate at time 5 is given by ws, and the vari
able et is an exogenous productivity parameter
for an individual in the f th period of life.
Output in the model is produced by competi
tive firms that combine capital (K ) and labor
(Z) using a constant-returns-to-scale production
technology. The production function is given by
) ^
- wset (1 —xs) + cst > °.
Ys stands for output in period s, and 0 is capital’s
share in production. Note that this functional form
implies that government purchases of goods and
services do not enter as inputs into the production
function. This amounts to ignoring government
investment in public services and infrastructure,
which could have positive effects on the produc
tivity of private capital and labor, as well as on the
level of total output. Aggregate capital and labor
supplies are determined from individuals’ asset
holding and leisure supply decisions:
(5)
8 Kormendi (1983) and Aschauer (1985) estimate that an extra unit
of government consumption, all else equal, reduces private consumption
http://fraser.stlouisfed.org/
by between 0.2 and 0.4 units.
Federal Reserve Bank of St. Louis
* s = ( l +»><•-»
t=1
V
'
and
(6)
v 7
5
eM ~ lst)
---Z = (1 + n) SY —■
5 v
' ^ (1 + n) '~55
/= l
Equations (5) and (6) represent the capital and
labor-market-clearing conditions, where I st
stands for the leisure of an individual aged t
at time 5.
Under the assumption of competitive markets,
the pre-tax real wage and interest rates are given
by
(7)
^ ( l - i K
v y
and
(8)
rs= Q (K s/L s) Q~\
We complete our description of the model with
the goods-market-clearing condition
(9)
■
Y = K*L™.
Y = Ci+ Gi+ Ks+1- K s ,
21
of an individual aged t and is based on estimates
obtained by Welch (1979). The equation used in
the following simulations is
where
55
(10)
q - d + » y I (1+^ , - g .
/=i v
7
Equations (8) and (9) assume that the deprecia
tion rate on physical capital is zero.
To solve the model, one must choose values for
the model’s parameters. Auerbach and Kotlikoff
parameterize the model based on findings of vari
ous empirical studies. Although we have retained
their choice of parameters in the simulations pre
sented here, we do not examine the sensitivity of
the results to parametric variation. However, tests
of parametric sensitivity in the A-K study indicate
that the results are likely to be fairly robust. In any
event, the primary purpose of this paper is to ex
amine the qualitative nature of the effects of the
policy changes considered.
The parameter p in equation (1), which deter
mines how an individual’s annual labor supply
responds to a change in the wage rate, is set to
0.8.9 The intertemporal elasticity of substitution,
y , is set to 0.25 based on various estimates.10
The pure rate of time preference, 8, is set to
0.015. This implies an annual real interest rate of
6.9 percent per year, which is slightly less than the
estimated marginal productivity of capital.11 The
leisure preference parameter, a, is set to 1.5; it is
chosen so that individuals in the middle of their
working lives work approximately 40 percent of
their nonsleeping hours. The parameter estimates
lie within the ranges estimated in various empiri
cal studies using U.S. data.
The parameter 0 in the production function,
which determines the share of capital in produc
tion, is set to 0.25, approximating the historical
share of capital. The constancy of this measure
over time suggests the use of a Cobb-Douglas
production function. The effects on output due
to increased government expenditure will be
sensitive to the age-specific productivity profile
that is assumed. Rather than assume a flat ageproductivity profile, we assume an inverted Ushaped profile. That is, productivity rises and
reaches a maximum at about the twenty-fifth year
of an individual’s working life, and declines there
after. The variable et represents the productivity
■
9 Ghez and Becker (1975), for example, estimate the value of p to
be 0.83.
■ 10 See, for example, Grossman and Shiller (1981), who estimate y
to lie between 0.07 and 0.35.
■ 11 We estimate that the average rate of return on capital was about
http://fraser.stlouisfed.org/
9 percent per year over the past decade.
Federal Reserve Bank of St. Louis
(11)
et = 4.47 + 0.033?- 0.00067/2.
The solution to the model is obtained by find
ing the wage and interest rates, so that labor
and capital markets clear in every period, s.
First, we solve the model for the initial steady
state, that is, before any policy changes are intro
duced. It is assumed that in this steady state, the
government consumes 15 percent of output and
levies a 15 percent proportional income tax to
finance it. We selected this rate for our experi
ments to mimic the level of government expendi
ture that has prevailed over the post-World War II
period. This implies that the government’s budget
is initially balanced. After a policy change is under
taken, we solve the model for 150 years into the
future. This is sufficient to ensure that the model’s
economy converges to the final steady state after
each policy change. Policy changes are assumed
to be unanticipated.
II. Permanent
Increases in
Government
Expenditure
Balanced-Budget
Increases
In the first simulation, government expenditure is
increased permanently by 5 percent of initial
steady-state output. Because government con
sumption was 15 percent of output in the initial
steady state, this represents a 33 percent rise,
which is financed by a balanced-budget increase
in income taxes. Thus, the government’s budget is
balanced both before and after the upturn in gov
ernment expenditure.
In the short run, higher income tax rates reduce
after-tax wage and interest incomes. These reduc
tions have an income effect on individuals’ con
sumption and labor supply. The decline in after
tax income leads to lower consumption and
longer hours worked. However, there are also
substitution effects. A lower after-tax wage rate
implies that leisure is cheaper and induces individ
uals to work fewer hours. The reduction in the
after-tax interest rate has an intertemporal substitu
tion effect leading to reduced saving and lower
labor supply. Because people work in order to
consume both today and tomorrow, the lower
after-tax interest rate reduces the incentive to work
22
for greater future consumption. The results
show that substitution effects dominate income
effects in the short run (see figure 1). Labor falls
by 0.5 percent, and saving declines to 1.8 per
cent, from 3-7 percent of output in the first
period. The reduction in hours worked leads to
a decline in output of 0.4 percent.
The lower saving rate causes the capital stock
to fall in the subsequent period. A lower capital
stock increases the marginal productivity of cap
ital, and hence the before-tax interest rate. This
helps to mitigate the intertemporal substitution
effects, causing the saving rate and hours worked
to expand gradually from their new lower levels.
As the charts in figure 1 show, the saving rate in
the long-run steady state is somewhat lower than
in the initial one.
After year six, individuals work longer hours
than they did before government expenditure
began to rise. The reduction in substitution effects
causes income effects to dominate eventually; in
the long mn, labor supply is higher by 1.1 percent.
Output, however, is lower due to the decrease in
the capital stock. The charts show that the conver
gence to the new steady state is gradual. The new
steady-state capital stock is reduced by 7.7 percent,
and output by 1.2 percent. Private consumption is
7.3 percent lower than it was before government
spending rose.
Increases in government expenditure cause
output to decline because an income tax is distortionary. That is, the higher taxes distort the laborleisure and savings decisions of individuals. Baxter
and King (1990) show that in a representativeagent model with lump-sum (nondistortionary)
taxes, permanent increases in government expen
diture actually cause output to be higher. No
within-period substitution effect is associated with
lump-sum taxes. Higher lump-sum taxes, how
ever, reduce lifetime resources, and individuals
optimally choose lower levels of consumption and
leisure, so that employment and output are higher.
It should be emphasized that increased output
does not imply that people are better off. This
depends on how much individuals on the margin
value private consumption and leisure compared
to public consumption.
Deficit-Financed
Increases
The next simulation shows the effects of an
identical increase in government expenditure
that is deficit financed. Deficit financing is used
for the first 10 years, after which taxes are
increased by enough to cover both greater
spending and the interest on the government’s
debt. This time profile of taxation results in inter
temporal substitution effects. Lower taxes today
compared to tomorrow induce individuals fac
ing higher future taxes to work more today and
less tomorrow. Figure 2 shows that labor supply
rises by 2.7 percent in the first period. It also
causes the younger generations to consume less
today in order to save for consumption tomor
row. Aggregate private consumption falls by 2
percent initially, but this is not enough to offset
the increase in government consumption. Thus,
the economy’s saving rate falls from 3.7 percent
to 2.3 percent. Furthermore, given the initial
stock of capital, the higher labor supply in the
short run causes a small rise in the interest rate,
from 6.7 percent to 6.8 percent. Higher labor
supply also causes output to jump by 2 percent
in the first year after the policy change.
A further effect arises from the intergenerational redistribution of resources caused by deficit
financing. Since taxes do not increase at all for the
first 10 years, some initial older generations escape
the burden of higher future taxes. Their lifetime
resources expand because of the higher interest
rates during this period. This induces greater con
sumption on the part of the older generations,
which helps to explain why the decline in total
private consumption is insufficient to offset the
increase in government consumption.
W hen taxes increase after year 10, the inter
temporal substitution effects are reversed.
Labor supply contracts sharply. This, along with
the continual decline in the capital stock, causes
output to fall. The interest rate drops dramat
ically, reflecting the increase in the capitallabor ratio in period 11. It continues to rise
thereafter, howrever, reflecting the increasing
marginal productivity of capital, as the capital
stock continues to shrink while hours worked
expand. In the new long-run steady state, the
capital stock is lower by 25.2 percent, and out
put is reduced by 7.3 percent. This crowdingout effect is much larger than the effect of the
balanced-budget increase in government expen
diture considered earlier. It reflects the greater
distortionary effect of the higher tax rates under
deficit financing that are imposed on young and
future generations to pay for the redistribution
toward the initial older generations.
23
FI GURE
1
The Effects of Pe rm an e n t
Balan ce d-B udge t Increases
in G o ve rn m e n t Consum ption
Output (% change)
Wage Rate3
2
1.00
0
-2
0.98
v
^
-----
0.96
-4
0.94
-6
-8
-20
1
0
1
20
1
40
1
60
1
80
1
100
120
0.92
-2 0
1
1
0
20
1
40
1
60
1
80
1
100
120
100
120
Years
Years
Capital Stock (% change)
Hours Worked (% change)
Saving Rate (%)
6
Years
Interest Rate (%)
Income Tax Rate (%)
Digitizeda.for
FRASER
The
wage rate in the initial steady state is normalized to unity.
http://fraser.stlouisfed.org/
NOTE: Horizontal lines represent values in the initial steady state. Percent changes are calculated from the initial steady state.
Federal SOURCE:
Reserve Bank
of St.
Louis
Authors’
calculations.
24
FI GURE
2
The Effects of Permanent
Deficit-Financed Increases
in Government Consumption
Wage Rate3
Output (% change)
Years
Capital Stock (% change)
Years
Hours Worked (% change)
Saving Rate (%)
6
-20
Years
20
40
60
80
Years
Interest Rate (%)
Years
a. for
TheFRASER
wage rate in the initial steady state is normalized to unity.
Digitized
NOTE: Horizontal lines represent values in the initial steady state. Percent changes are calculated from the initial steady state.
http://fraser.stlouisfed.org/
FederalSOURCE:
Reserve Authors’
Bank of calculations.
St. Louis
100
120
25
III. Temporary
Increases in
Government
Expenditure
Balanced-Budget
Increases
The next set of simulations examines the effects
of a five-year increase in government expendi
ture financed by a contemporaneous increase in
taxes. One can think of these experiments as
being caused by a five-year war, during which
taxes are raised to pay for military operations. In
the long mn, years after the war ends, all vari
ables return to the values they held prior to the
expansion of government spending. The reason
is that tax rates and the share of government ex
penditure in output are both identical to their
pre-war levels.
The charts in figure 3 show the effects of
these policies on capital, labor, and output.
Taxes are higher during the war years. Substitu
tion effects dominate income effects, since a
five-year tax increase does not reduce lifetime
income by much. Because of the intertemporal
substitution effect, people choose to work less
during the war years when taxes are high, and
to work more in later periods when taxes are
lower. Labor supply is also reduced due to the
within-period substitution effect that operates
on the labor-leisure choice.
Labor supply falls by 2.6 percent, causing out
put to decline 2.0 percent in the first period of the
five-year war. Because capital is fixed at the initial
steady-state level in the first year, the large nega
tive effect on output in the first period is solely
due to the substitution effects on labor supply.
If government expenditure were high for only
one year (instead of five), labor supply would fall
by 4.0 percent (versus 2.6 percent for the five-year
war). The larger decline in labor supply is due to
the stronger intertemporal substitution effect in
the case of a one-year war. There are two rea
sons for this. First, unlike the five-year case,
lower labor supply during periods of high taxa
tion cannot be spread over time in the one-year
case. Second, a greater number of generations
will face lower future taxes in a one-year war
than in a five-year war. Hence, the first-period
effects on labor supply and thus on output are
larger in the one-year war.
Given the desire of individuals to smooth
their consumption over time in the face of tem
porarily higher taxes, saving initially falls from
3.7 percent of output to -0.8 percent of output.
Thus, although the income-tax rate rises from
15 percent to 20.4 percent in the first year, con
sumption falls by only 3.0 percent. The dra
matic decline in saving shows up in period two,
as capital falls by nearly 1.2 percent. Labor sup
ply, consumption, output, and saving continue
to be depressed during the second through the
fifth years of the war, when taxes are still high.
Thus, the capital stock continues to decline until
year six. After the war is over and government
expenditure returns to its original level, all vari
ables gradually return to their pre-war levels.
Deficit-Financed
Increases
Most temporary increases in government spend
ing are the result of wars, and most wars are defi
cit financed. That is, taxes are not raised during
the war, but only at some time after the war has
ended. The final simulation shows the effects of a
five-year war when taxes are not increased until
the year after the war concludes. Thus, taxes are
slightly higher from year six on, rising by just
enough to cover the additional interest expense
on the war debt.
The charts in figure 4 show the effects that a
five-year deficit-financed war can be expected to
have on the economy. The tax profile facing pri
vate individuals has income and substitution
effects, and again, income effects are small and
substitution effects dominate. During the war
years, taxes are lower than their level in later peri
ods. Hence, individuals choose to work longer
hours during the war years and to curtail labor
supply in later periods. During the first year of the
war, labor supply increases by 1.2 percent. Since
capital is fixed during the first period, the higher
labor supply causes output to rise by 0.9 percent
and leads to a slight increase in the interest rate.
Private consumption drops by 0.9 percent as
individuals save more for future consumption.
This decrease, however, is insufficient to off
set the increase in government consumption.
Although private saving rises, aggregate saving is
depressed because of the larger decline in govern
ment saving (that is, the government saves noth
ing in the initial steady state and is a net borrower
during the war years). This leads to a decline in
the capital stock over subsequent years. A lower
capital stock, coupled with lower hours worked
because of higher taxes, causes output to fall even
further. In the long-run steady state, the capital
stock is 7.6 percent lower, labor supply is 0.6 per
cent lower, and output is 2.4 percent lower com
pared with the initial steady state.
26
FI GURE
3
The Effects of Temporary BalancedBudget Increases in Government
Consumption
Wage Rate3
Output (% change)
Years
Capital Stock (% change)
Years
Hours Worked (% change)
Saving Rate (%)
6
5
4
3
2
1
0
-1
-2
-2 0
Years
0
20
40
60
80
Years
Interest Rate (%)
Years
a. for
TheFRASER
wage rate in the initial steady state is normalized to unity.
Digitized
NOTE: Horizontal lines represent values in the initial steady state. Percent changes are calculated from the initial steady state.
http://fraser.stlouisfed.org/
FederalSOURCE:
Reserve Authors’
Bank of calculations.
St. Louis
100
120
H
FI GURE
4
The Effects of Temporary
Deficit-Financed Increases
in Government Consumption
Output (% change)
Wage Rate3
Hours Worked (% change)
Years
Income Tax Rate (%)
-20
0
20
40
60
80
100
120
Years
a. The wage rate in the initial steady state is normalized to unity.
NOTE:
Horizontal lines represent values in the initial steady state. Percent changes are calculated from the initial steady state.
http://fraser.stlouisfed.org/
SOURCE: Authors' calculations.
Federal Reserve Bank of St. Louis
IV. Conclusion
This paper has analyzed the effects of both
permanent and temporary changes in govern
ment expenditure on labor supply, interest rates,
output, and the capital stock. Both the short- and
long-run effects depend critically on whether the
higher expenditures are financed with higher
taxes initially or with government budget deficits.
A simulation in which government expendi
tures increased permanently from 13-7 to 22.1
percent of GNP (as they did over the last four
decades) led to a long-run decline in output of
2.1 percent. This number is a benchmark esti
mate of the effect on output because of perma
nently higher government consumption. With
deficit financing, output is higher in the short
run because of the increase in labor supply in
duced by the intertemporal substitution effects
of lower taxes earlier and higher taxes later.
However, the long-run steady-state level of out
put is lower with deficit financing than without
it. This occurs because of the higher tax rates
necessary under deficit financing to service the
accumulated debt.
Temporary increases in government expendi
ture, if financed by contemporaneous tax hikes,
result in temporary declines in output because
of the within-period substitution effect of the
currently high taxes on the labor-leisure margin
of choice. This effect is magnified by the inter
temporal substitution effect. Individuals sub
stitute current for future leisure because of the
temporary increase in taxes. When a balanced
budget is maintained during a temporary in
crease in government spending, all variables
return to their initial steady-state levels in the
long run. Under deficit financing, however,
long-run output is slightly lower because of the
adverse effects on labor supply caused by the
higher taxes necessary to service the debt accu
mulated during the war years.
Unlike the case in the representative-agent
model, output increases only in the presence of
deficit-financed government expenditure. This
is true for both permanent and temporary in
creases in government spending. W hen revenue
is raised in a balanced-budget fashion, output
declines. This is a result of the distortionary na
ture of taxation that induces intratemporal sub
stitution in favor of working more hours, as well
as intertemporal substitution in favor of work
ing when taxes are low.
A further reason for the difference in results
between this model and the representativeagent model is the intergenerational redistribu
tion aspect of deficit financing. Some older
generations escape higher future tax burdens
and as a result consume more than they other
wise would. This leads to higher interest rates
that again induce greater work effort on the part
of the labor force.
m
References
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2 (March 1989), pp. 177-200.
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bridge University Press, 1987.
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Ghez, Gilbert R., and Gary S. Becker. The Allo
cation o f Time a n d Goods over the Life
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Grossman, Sanford J., and Robert J. Shiller. “The
Determinants of the Variability of Stock Mar
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(October 1981), pp. 914-27.
Welch, Finis. “Effects of Cohort Size on Earn
ings: The Baby Boom Babies’ Financial Bust,”
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Wynne, Mark A. “The Aggregate Effects of Tem
porary Government Purchases,” Federal
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9007, April 1990.
Deregulation and the
Location of Financial
Institution Offices
by Robert B. Avery
Introduction
The past 15 years have witnessed major changes
in the regulation and structure of the U.S. financial
services industry. These changes have been driven
by technology, by the emergence of new, largely
unregulated competitors, and by the general per
formance of the economy. Consequently, a wide
array of new products and services and more com
petitive pricing and delivery systems have been
made available to consumers. But some argue
that these changes have come at a cost, alleging
that certain consumers, particularly those in lowincome and minority neighborhoods, have been
abandoned by the banking system.
Concern has focused primarily on two areas:
depository services and mortgage and consumer
lending. Consumer groups contend that new mar
ket pressures and regulatory freedom have led
financial institutions both to establish explicit fees
for depository services that had traditionally been
offered free of charge and to direct their branch
systems to serve more affluent (and profitable)
customers. Similar arguments have been made
about mortgage and consumer lending, with
financial institutions accused of deliberately limit
ing their lending in poor and minority areas. The
industry has countered by noting that if fees have
Robert B. Avery is a professor in
the Department of Consumer Eco
nomics and Housing at Cornell
University and a research asso
ciate at the Federal Reserve Bank
of Cleveland. The author grateful
ly acknowledges useful comments
and suggestions from Rosemary
Avery, Glenn Canner, Randall
Eberts, George Galster, Mark
Sniderman, and James Thomson.
Fungya Huang provided helpful
research assistance.
risen, it is because of higher costs; if offices have
been closed, it is because they are unprofitable;
and if fewer loans have been made in lowincome and minority areas, it is because demand
there has slipped.
Despite considerable debate in both the
media and academic circles, there has been sur
prisingly little hard data produced to support
either argument. Thus, not only are the underly
ing causes and consequences of change in the
financial system at issue, but so are the facts
about the size and scope of such change. This
article looks at one small aspect of the debate:
changes in the location of financial institution
offices. Telephone book Yellow Pages for 1977
and 1989 are used to estimate the pre- and post
deregulation size and distribution of the finan
cial industry’s branch system in the metropolitan
areas of Detroit, Cleveland, Philadelphia, Bos
ton, and Atlanta. In assessing these data, I at
tempt to determine whether a disproportionate
number of offices have been closed in lowincome and minority neighborhoods over this
period, and also whether such neighborhoods
are currently served by disproportionately
fewer offices. The comparisons control for pop
ulation and other demographic factors such as
housing and employment.
31
Clearly, restricting the study to five metropoli
tan areas limits its usefulness. However, all of
the cities chosen have been the subject of media
allegations of discrimination by their respective
banking systems. Each not only has large and
geographically segregated minority communi
ties, but also a well-defined banking market
with few branching restrictions, offering finan
cial firms a wide range of options with which to
respond to changing economic conditions.
Thus, one can argue that if changes in the finan
cial services industry have hurt low-income and
minority consumers disproportionately over the
past 15 years, the effects would likely show up
in one of these cities.
I. Background
The financial services industry looked quite differ
ent in the mid-1970s than it does today. The con
sumer depository services market was dominated
by commercial banks, but federal and state regula
tions limited the types of products they could offer,
the prices they could charge, and the geographic
areas in which they could operate. Restricted in
their ability to compete for consumer deposits
through prices, banks competed through such
nonprice means as extensive branching networks,
free or low-cost accounts, and other subsidized
services. Savings and loans (thrifts) and credit
unions competed with commercial banks for
savings-type accounts; however, they could not
offer transaction services and were required to
operate under price restrictions similar to those
that governed commercial banks. In part because
of state usury laws, the consumer loan market was
highly segmented, with finance companies serv
ing the higher-risk end of the market and commer
cial banks serving the lower-risk end. The homeloan market was dominated by commercial banks
and savings and loans; mortgage bankers played
a comparatively small role.
Today, the structure of the industry is consid
erably different. Starting in 1981, price restrictions
on depository services were gradually lifted, and
by 1986, they were virtually eliminated. Thrifts,
credit unions, money market funds, and even
finance companies can now actively compete for
any type of consumer depository account. Further
more, because many state usury laws have been
eliminated, the nature of the consumer loan mar
ket has also changed. Consumers are now much
more likely to secure open-end lines of credit that
can be drawn down at their convenience rather
than the closed-end contracts tied to a specific
purchase that had characterized the industry in
the 1970s. Commercial banks, thrifts, and
finance companies now appear to compete
actively for all segments of the consumer loan
market. The mortgage market has seen similar
changes. Growth of the secondary market has
resulted in considerable standardization of the
loan application process and has ensured that
mortgage originators have a ready outlet for
their loans. This has made it much easier for
firms that specialize in originating loans (rather
than holding them for their portfolio) to flour
ish. Moreover, federal preemption of usury ceil
ings on home-purchase loans has helped to
guarantee an adequate flow of mortgage credit.
The effect of these changes on consumers is
unclear. O n one hand, consumers appear to be
the beneficiaries of more competitive pricing in
both the depository and loan markets. O n the
other hand, the shift toward explicit and competi
tive pricing may have harmed those consumers
who enjoyed cross-subsidies under the old, heav
ily regulated system. The potential for conflicting
effects was foretold in 1979 by two consumer
groups testifying before Congress on the removal
of depository price restrictions. The Consumers
Union strongly supported deregulation, yet the
Consumer Federation of America hesitated, argu
ing that the poor might be adversely affected (see
Brobeck and Cooper [1991]).
Arguments supporting the view that lowincome consumers have been harmed by dereg
ulation can be summarized as follows (see
Canner and Maland [1987]):
• Explicit pricing of depository services may
price some consumers out of the market,
pushing such items as a basic checking ac
count beyond their reach.
• The reduction of bank profit margins stem
ming from more competitive market condi
tions may lead depository institutions to close
marginal offices, which are more likely to be in
low-income neighborhoods. Furthermore,
more-lenient federal merger guidelines could
accelerate the closure process.
• Competitive forces may move banks up
market, shifting their business toward more
affluent consumers w ho purchase many
products.
• Raised credit standards resulting from the
shift toward open-end loans may ration the
poor out of the consumer loan market. If
financial firms prefer to lend to their
depository services customers, consumers
priced out of the depository market may be
rationed out of the loan market as well.
The gist of these arguments is that the pricing
system in effect prior to deregulation favored
32
low-income consumers, who gave up little in
forgone interest because of small account sizes,
but benefited substantially from underpriced
services. In effect, such pricing amounted to a
cross-subsidy of low-income consumers, but be
cause profit margins were high enough, banks
were satisfied with the arrangement. Under an
explicit pricing system and narrower margins,
these same consumers may be priced out of the
market unless financial institutions are forced to
offer subsidized basic depository accounts. But
Canner and Maland (1987) point out that requir
ing firms to offer such accounts could raise the
cost of doing business in poorer neighborhoods
and thus lead to office closures there.
Most discussion about the effects of deregula
tion has focused on low-income consumers.
There is a long-standing concern that minorities,
even those who are not poor, have been ill served
by the financial services industry (Avery and
Buynak [1981]). Surveys have consistently shown
that minorities are less likely than whites of the
same income level to own checking or savings
accounts or to use depository institutions for
loans. Analysts disagree, however, about whether
this is a result of discrimination, differential
demand, or sound economic reasons such as cost.
Moreover, it is unclear what effect deregulation
may have had on minorities. If disproportionately
poor service in the minority community stemmed
from discrimination, then one might expect condi
tions to improve as competitive pressures made it
more difficult for firms to discriminate. On the
other hand, if reduced service arose from cost fac
tors or weak demand, then it might be exacer
bated by increased competition and price changes.
Regulatory responses to these potentially
adverse effects on low-income (and minority)
consumers have been mixed. The 1975 Home
Mortgage Disclosure Act and the 1977 Commu
nity Reinvestment Act (CRA) established federal
regulatory processes to encourage financial in
stitutions to meet the credit needs of their entire
community — including low-income areas —
as long as such practices were consistent with
safe and sound banking practices. Both Acts
were strengthened in 1989; however, their
specific implications, as well as regulators’ abil
ity to take a proactive role in their enforcement,
remain uncertain (Avery [1989]).
Federal legislation related to basic depository
services has been introduced before Congress
many times, but none of these efforts has been
successful. In 1986, the Federal Financial Institu
tions Examination Council approved a policy
statement that endorsed and encouraged finan
cial institutions to offer a basic package of
depository services to low-income customers
(Canner and Maland [1987]). Although the CRA
pertains primarily to credit needs, an institu
tion’s record of opening and closing offices —
as well as the services it provides at specific
locations — has been recognized in the CRA
assessment procedures (Mitchell [1990]). This
link was made more explicit in a joint statement
issued by the federal financial institution regu
latory agencies in March 1989. The new policy
allows provision of basic financial services such
as low-cost checking accounts to be considered
in determining an institution’s CRA rating.
Despite concerns about the impact of deregu
lation on low-income consumers and on the
level of service within the black community in
particular, very little systematic evidence has
been produced. Results of mortgage lending
studies are mixed. Using 1981 data, Avery and
Canner (1984) find statistically significant evi
dence that, controlling for other factors, minority
neighborhoods received fewer mortgage loans
from commercial banks and savings and loans
in only nine of 100 standard metropolitan statis
tical areas (SMSAs) studied. Using more recent
data, however, Bradbury, Case, and Dunham
(1989) find substantial evidence of such effects
in Boston. In addition, detailed newspaper
accounts in Atlanta, Detroit, Cleveland, and Bos
ton all produced evidence that led some to con
clude that discrimination existed in these cities’
mortgage markets in the late 1980s.1
Evidence concerning deregulation’s impact
on the use of depository services is also incon
clusive (Canner and Maland [1987]). Household
surveys taken by the Federal Reserve Board in
1977 and 1983 show a decline in the propensity
of the lowest-income consumers to use deposi
tory accounts over this period. However, Canner
and Maland point out that this drop-off can be
explained by rising unemployment and demo
graphic changes over the same interval. They also
cite a 1986 Federal Reserve Board survey showing
that of those respondents who lacked a checking
account, none named fees or minimum balance
requirements as the reason. Scott (1988), citing a
survey of low-income consumers, reports that
two-thirds of the respondents w ho did not
have a checking account had never had one.
Thus, although there is evidence of a large,
disproportionately black population of lowincome consumers w ho do not ow n depository
■
1 See “The Color of Money," Atlanta Constitution, May 1-4,1988,
p. 1; “The Race for Money,” Detroit Free Press, June 24-27,1988, p. 1;
“Banks Give Poor Areas Few Loans," The Plain Dealer, October 10,
1989, p. 1; and “Inequities Are Cited in Flub Mortgages," The Boston
Globe, January 1,1989, p. 1.
33
accounts, it is unclear whether the size of this
population has increased since deregulation.
Another potential means of evaluating the im
pact of changes in the financial services indus
try on low-income and minority consumers is to
look at office closings and openings. If lowincome and minority areas have suffered a dis
proportionate number of such closures over the
past 15 years, this could signal a reduction in
services in these neighborhoods. Unfortunately,
few studies of office closures have been con
ducted.2 Section II attempts to fill this gap by
comparing the financial industry branch systems
in Detroit, Cleveland, Philadelphia, Boston, and
Atlanta at the onset of deregulation in 1977
against the systems in place in 1989-1990. The
purpose of these comparisons is twofold: to
determine whether a disproportionate number
of offices were closed in low-income and minor
ity neighborhoods over this period, and to test
whether such neighborhoods are currently be
ing served by disproportionately fewer offices.
II. Empirical Setting
The empirical procedures used to examine each
of the five cities were similar. I selected the geo
graphic areas covered by the “center city” Yellow
Pages in each metropolitan region as the study
areas for each city. Typically, this zone included
the city proper and most inner suburbs. For Bos
ton and Cleveland, however, substantial por
tions of the outer suburbs were included as well.
Except for Atlanta, all areas were of roughly
equal population.3
I compiled basic data on office locations as
follows: The 1977 and 1989—1990 Yellow Pages
for each city were used to compile address lists
for four separate types of institutions: commer
cial banks, thrifts (savings and loans and mutual
savings banks), check cashing companies, and
loan (both business and consumer finance) and
mortgage companies.4 Institutions included
under the headings Banks, Savings a n d Loans,
Check Cashing Service, Financing, Loans, or
Mortgages were added to the lists. I classified
offices listed under multiple headings according
to their primary activity. For example, a bank
office was counted as a commercial bank unless
it was clearly only a loan production office.
Commercial and mutual savings bank addresses
were also cross-checked against the June 1977
and June 1988 Summary of Deposits address list
filed with federal regulators, resulting in the
addition of a few offices not listed in the Yellow
Pages. I did not count drive-in windows and
automated teller machines (ATMs) unless they
either had separate addresses (and were listed
in the Yellow Pages) or qualified as separate
offices under federal guidelines.
Institutional offices were further sorted and
aggregated by U.S. Postal Service five-digit ZIP
Code areas (ZCAs) corresponding to the study
area of each city. In total, 230 ZCAs were used.’
Offices outside the study areas were discarded
even though listed in the Yellow Pages.
The decision to aggregate data to the ZCA
level was based on several factors. First, it is
comparatively easy to classify addresses by ZCA
with a high degree of accuracy. Second, ZCAs
are large enough (30,000 residents on average)
to encompass both residential areas and the busi
ness districts that serve them. This is not so for
some other measures, including census tracts.
Although census tracts are designed to be eco
nomically and demographically homogeneous,
they are comparatively small (4,000 to 5,000 per
sons) in large metropolitan areas. Thus, many
residential census tracts contain few business
offices, yet are located next to business districts
that provide ready access to their residents.6
Though this is not necessarily a drawback for
studies that use households as their unit of
analysis, it poses a real problem for studies such
as this one that use financial institution offices
as the observational unit.7
Using ZCAs also has disadvantages. For
instance, these areas were set up for the
■
■
2 One exception is a report in The New York Times (January 30,
1989) showing that bank closures in the New York SMSA between 1985
and 1988 were disproportionately located in low-income areas. Dennis
(1984) reports evidence from a Federal Reserve Board study showing that
the overall ratio of commercial bank openings to closures fell from 5:1 in
1979 to 1.9:1 in 1983.
5 Twenty-eight of the 258 ZCAs corresponding to the study areas
were excluded because they contained too few residents. This criterion
eliminated the central business districts of each city.
■
3 The Atlanta study area included 825,000 residents, while the
other four areas ranged from 1,400,000 to 1,650,000 residents.
6 Cuyahoga County, Ohio (Cleveland), for example, contains 357
census tracts but only 50 ZCAs. In 1989, an average of 4,010 people
lived in each census tract, compared with 28,634 people in each ZCA.
The average number of commercial banking offices in these ZCAs was
5.6, while census tracts averaged 0.8. More than half of the census tracts
had no banking offices at all.
■
■
■
4 Phone book publication dates were as follows: 1977 and 1989
(no month given) for Atlanta, January 1978 and 1990 for Boston, May
1977 and 1989 for Cleveland, September 1977 and 1988 for Detroit, and
http://fraser.stlouisfed.org/
March 1977 and 1990 for Philadelphia.
Federal Reserve Bank of St. Louis
7 One alternative would be to consider offices within contiguous
census tracts as accessible to an individual. However, this procedure
might erase many of the inherent advantages of homogeneity that make
census tract data attractive in the first place.
a
TABLE
1
Sample Characteristics, by ZCAs
Boston
Cleveland
Detroit
Philadelphia
Total
$36,389
61.5
$32,132
59.6
$25,846
33.3
$24,051
18.6
$30,509
45.7
27.7
10.8
27.7
12.8
30.9
35.7
48.8
32.6
32.6
21.7
38.1
45.5
8.9
80.0
17.3
66.0
41.9
31.0
34.6
41.9
25.7
56.1
15.2
39.4
15.4
4.6
17.0
17.0
28.6
40.5
23.3
34.9
19.6
24.3
$53,875
0.43
$58,217
0.40
$53,544
0.39
$28,953
0.39
$28,087
0.40
$45,662
0.40
0.94
41.1
63.7
0.51
25.8
65.0
0.46
25.6
56.3
0.39
21.7
49.4
0.30
16.2
54.6
0.50
25.4
58.2
22,889
24,940
24,866
24,672
32,960
30,059
41,524
34,569
41,063
37,734
32,306
30,061
33
54.5
65
33.8
47
29.8
42
61.9
43
95.3
230
52.6
Atlanta
Median annual household income, 1989
$30,964
Average ZCA median
Percent of ZCAs above $30,000
45.5
Percent of ZCAs between
$20,000 and $30,000
30.3
24.2
Percent of ZCAs below $20,000
Racial composition, 1989
Average percent black
Percent of ZCAs below 10% black
Percent of ZCAs between 10% and
50% black
Percent of ZCAs above 50% black
Housing, 1980
Average median value
Number of units per capita
Employment3
Employees per capita, 1986
Firms per 10,000 people, 1986
Percent white collar, 1980
Population
Per ZCA, 1977b
Per ZCA, 1989
ZCA distribution
Number of ZCAs
Percent of ZCAs in center city c
a. 1986 employm ent figures are deflated to per capita terms using 1989 population estimates.
b. 1977 population figures are estimated as the weighted average of 1980 (weight o f 0.7) and 1970 (weight of 0.3) population values.
c. A ZCA is considered “center city” if the majority o f its area falls within the boundaries of the city proper.
NOTE: Sample excludes a total of 11 central-business-district ZCAs and 17 other ZCAs with fewer than 5,000 residents in 1989SOURCE: Author’s calculations based on CACI data.
convenience of the Postal Service and its ground
transportation system, not for statistical analysis.
Thus, boundaries do not necessarily correspond
to natural socioeconomic divisions and in many
cases cut across city or county lines. ZCAs also
suffer from the same problem as census tracts in
that residents on the edge of one area may do
their shopping in another. Nevertheless, ZCAs
do vary substantially in their economic and ra
cial composition, even if not by design. If finan
cial institutions differentially serve black and
low-income neighborhoods, gross patterns
should be apparent at the ZCA level (though
more accurate analysis might require a different
unit of geographic aggregation).
Independent variables, also defined at the
five-digit ZCA level, were primarily constructed
from data reported in The Sourcebook o f Demo
http://fraser.stlouisfed.org/
graphics a n d Buying Powerfo r Every ZIP Code
Federal Reserve Bank of St. Louis
in the USA, published by Consolidated Analysis
Centers, Inc. (CACI) in 1989. CACI aligns census
data with ZCA boundaries to estimate 1980
measures of median household income, median
owner-occupied housing value, population
(total and by race), and number of housing units
(a proxy for household size). The organization
also provides 1989 estimates of population and
median household income by ZCA, 1986 esti
mates of the number of firms and employees
operating in each ZCA (based on independent
information), and 1980 white-collar employ
ment figures (based on census data).
Characteristics of the sample, broken down
by city, are given in table 1. Although the five
city samples correspond to areas of roughly
equal size, they reflect differing demographic
characteristics, with Detroit and Philadelphia
clustered into one group, Cleveland and Boston
35
TABLE
2
Number of Offices per
10,000 People, 1977 and 1989
Atlanta
Commercial banks
1977
1989
Boston
Cleveland
Detroit
Philadelphia
Total
2.76
3.65
1.74
1.70
1.73
1.96
1.46
1.60
1.17
1.30
1.73
1.94
0.82
0.98
1.64
1.38
1.35
1.83
0.34
0.42
0.96
1.16
1.10
1.20
0.03
0.50
0.01
0.10
0.05
0.18
0.01
0.19
0.25
0.94
0.07
0.35
4.67
5.04
0.81
1.51
1.32
0.84
0.62
0.31
0.66
0.36
1.41
1.44
8.27
10.17
4.20
4.68
4.45
4.81
2.44
2.53
3.04
3.76
4.30
4.93
Thrift institutions
1977
1989
Check cashing companies
1977
1989
Loan and mortgage companies
1977
1989
Total
1977
1989
SOURCE: Author’s calculations based on Yellow Pages data.
into another, and Atlanta showing characteristics
of both pairs.
For Detroit and Philadelphia, most of the studyarea ZCAs are located in the center city. Although
each center city contains many middle-income
neighborhoods, most of the middle- and upperincome suburbs are excluded. The racial com
position of the middle-class neighborhoods of
the two cities differs somewhat. Philadelphia
contains more middle-income white ethnic
areas, while Detroit’s middle-class neighbor
hoods are more likely to be black. Each city suf
fered a significant decline in population between
1977 and 1989 (16.7 percent in Detroit and 8.1
percent in Philadelphia). Housing prices, median
family income, and employment are similar, but
significantly below those of the other three cities.
About one-third of both cities’ ZCAs are more
than 50 percent black and have median annual
household incomes of less than $20,000.
Detroit’s and Philadelphia’s commercial
banking markets are also comparable. Each city
is dominated by five or six large branch-banking
systems that have undergone significant change
since 1977 (through mergers and consolidation
in Detroit and through purchases by out-of-area
banks in Philadelphia). Their thrift markets
differ somewhat, though. Detroit has compara
tively few thrifts, whereas Philadelphia has many
small, neighborhood thrifts plus two large
http://fraser.stlouisfed.org/
branch systems.
Federal Reserve Bank of St. Louis
Data for the Cleveland and Boston study
areas also track fairly closely. Unlike Philadel
phia and Detroit, each contains many of the
cities’ suburbs, with only about one-third of the
study-area ZCAs located in the center city. In
addition, fewer than 20 percent of each city’s
study-area ZCAs have black majorities or
median annual household incomes of less than
$20,000, and median housing values are almost
twice those of Philadelphia and Detroit. Employ
ment data also differ between the two pairs, with
more employees per capita and more white-collar
workers in Boston and Cleveland.
Both Boston and Cleveland have several
areawide branch-banking systems. Consolida
tions occurred between 1977 and 1989, generally
through holding companies rather than mergers.
Both cities also have large, competitive thrift
systems.
The Atlanta study area differs from the other
four in several ways. As noted above, Atlanta’s
sample population is only slightly more than
half that of the other four cities. Moreover,
Atlanta’s population is growing, whereas that of
the other cities is contracting. Housing values are
similar to those of Boston and Cleveland, while
racial composition is comparable to that of Phila
delphia and Detroit. Median income and the
percentage of study-area ZCAs located in the cen
ter city fall between the Cleveland/Boston and
Philadelphia/Detroit range. The status of Atlanta
B3
TABLE
3
Number of Offices per 10,000 People
by Race and Income, 1977 and 1989
Median Annual Household Income3
Percent Black3
Above
$30,000
$20,000$30,000
Below
$20,000
Below 10
10-50
Above 50
1.93
2.29
1.66
1.77
1.40
1.47
1.90
2.25
1.73
1.91
1.32
1.24
Thrift institutions
1977
1989
1.44
1.64
1.02
1.03
0.50
0.54
1.49
1.67
0.87
1.00
0.38
0.28
Check cashing companies
1977
1989
0.00
0.08
0.05
0.46
0.22
0.73
0.02
0.15
0.04
0.43
0.18
0.74
Loan and mortgage companies
1977
1989
1.98
2.40
1.03
0.80
0.77
0.42
1.77
2.12
1.15
0.81
0.77
0.41
Total
1977
1989
5.35
6.41
3.76
4.06
2.88
3.15
5.19
6.19
3.78
4.16
2.66
2.67
Number of ZCAs
105
75
50
129
45
56
Commercial banks
1977
1989
a. Based on ZCAs sorted by 1989 characteristics.
SOURCE: Author’s calculations.
as a regional distribution center is reflected in its
large number of firms and employees.
Atlanta not only has the highest number of
banking offices per capita of the five study sites,
but its banking industry (particularly branch
banking) grew dramatically over the 13 years
covered here. The number of mortgage com
pany offices, including many regional head
quarters, also rose considerably and at a much
higher rate than in any of the other cities.
III. Results
Modest growth occurred in the per capita num
ber of offices for almost all institution types and
cities between 1977 and 1989 (table 2). Overall,
per capita growth was up 12 percent for com
mercial bank offices, 9 percent for thrift offices,
500 percent for check cashing offices, and 2 per
cent for loan and mortgage company offices.
The only sectors showing a decline in service
were commercial banks and thrifts in Boston
and loan and mortgage companies in Cleveland,
Detroit, and Philadelphia.8 The uptick in the
per capita number of branches for each type of
institution seems to contradict the commonly
held belief that deregulation would lead to a
reduced number of “brick and mortar” offices.
Indeed, branch services seem to have grown
over this period.
Growth in the number of offices between 1977
and 1989 does not appear to be uniform across
socioeconomic groups (table 3). While the per
capita number of thrift and commercial bank
offices jumped 14 percent in predominantly white
and integrated ZCAs, areas that were more than
50 percent black showed an 11 percent decline.
Interestingly, this difference does not show up
when ZCAs are arrayed by income, even though
■
8 The latter figures are somewhat deceptive because they reflect a
change in the mix between mortgage and loan companies. In all five
cities, loan and finance companies showed a substantial decline in the
per capita number of offices over the study period, while mortgage com
pany offices grew in importance. Atlanta is a large regional mortgage cen
ter and thus has an artificially inflated number of mortgage production
offices. The Boston real estate market also was very active during the
1977-1989 period, and its mortgage company offices grew rapidly.
37
TABLE
4
City Differences in Commercial
Banks’ and Thrifts’ Level of Service
Due to Race or Income
Commercial banks
10%-50% black
Above 50% black
R2
$20,000-$30,000 income
Below $20,000 income
R2
Thrift institutions
10%-50% black
Above 50% black
R2
$20,000-$30,000 income
Below $20,000 income
R2
Atlanta
Boston
Cleveland
Detroit
Philadelphia
Total
0.61
(1.83)
-2.53a
(1.35)
0.13
-0.70
(0.50)
-1.35
(0.86)
0.06
0.37
(0.45)
-0.84a
(0.45)
0.10
-0.823
(0.48)
- l.l6 b
(0.44)
0.16
-0.63
(0.38)
-0.94b
(0.34)
0.17
-0.38
(0.31)
-1.35b
(0.31)
0.21
-0.98
(1.49)
-2.63
(1.60)
0.08
0.24
(0.42)
0.01
(0.61)
0.01
-1.02b
(0.37)
-0.51
(0.50)
0.15
-0.41
(0.49)
-0.63
(0.47)
0.04
-0.48
(0.43)
-0.61
(0.46)
0.04
-0.44
(0.28)
-0.80b
(0.33)
0.17
-0.73
(0.53)
-1.46b
(0.39)
0.32
-0.38
(0.31)
-1.37b
(0.54)
0.11
-0.38
(0.42)
-1.93b
(0.42)
0.33
-0.45b
(0.20)
-0.59b
(0.18)
0.22
-0.79b
(0.27)
-1.40b
(0.24)
0.46
-0.57b
(0.15)
-1.28b
(0.15)
0.38
- l.l6 b
(0.44)
-1.22b
(0.47)
0.25
0.01
(0.26)
-0.70a
(0.38)
0.06
-1.42b
(0.36)
-1.12b
(0.49)
0.28
-0.353
(0.19)
-0.59b
(0.18)
0.21
-0.20
(0.35)
-0.96b
(0.37)
0.19
-0.56b
(0.15)
-0.93b
(0.17)
0.28
a. Statistically significant at the 10 percent level.
b. Statistically significant at the 5 percent level.
NOTE: Dependent variable: num ber of offices per 10,000 people in 1989- Coefficients are reported for two separate regressions, one for in
come and one for race. Each regression had an intercept and two dum m y variables. Total regressions (colum n 6) had separate intercepts for
each city. Standard errors are in parentheses.
SOURCE: Author’s calculations.
the race and income divisions are designed to sep
arate the sample into groups of similar size. The per
capita number of thrift and commercial bank offices
increased 6 percent in the poorest ZCAs (those with
a median annual household income of less than
$20,000) — a growth rate below that of the richest
areas (17 percent) but above that of the middleincome areas (4 percent).
Check cashing and loan and mortgage com
panies show a more consistent relationship with
race and income. Check cashing companies
grew most rapidly in low-income and predomi
nantly black areas, while the number of loan
and mortgage company offices contracted sub
stantially in all but the predominantly white and
high-income areas. The latter figures reflect the
predominance of mortgage companies in highincome areas and of finance companies in lowand middle-income and black areas.
Although the change in the number of finan
cial institution offices between 1977 and 1989 does
not appear to be strongly related to income, there
is a significant correlation between income and the
number of offices existing in 1989- On a per capita
basis, low-income areas had 35 percent fewer
commercial bank offices and less than one-third
as many thrift offices as high-income areas. These
differences are even larger when predominantly
black areas are compared with predominantly
white areas.
City differences in the level of service provided
by commercial banks and thrifts are shown in
table 4. Coefficients from simple regressions
differentiating only race and income (separately)
are given for each city. The coefficients for the
two racial dummy variables reflect the gross dif
ference in the number of offices per capita be
tween integrated/predominantly black areas
and predominantly white areas for each city in
1989. Coefficients for the two income dummies
Eil
TABLE
5
Factors Affecting Financial
Intermediaries’ Level of Service
Intercept
10%-50% black
Above 50% black
$20,000-$30,000 income
Below $20,000 income
Center city
White collar (%)
Home value ($10,000)
Housing units per capita
Firms per 10,000 people
Employees per capita
Boston
Detroit
Philadelphia
Atlanta
R2
Commercial
Banks
Thrift
Institutions
Check
Cashing
Companies
Loan and
Mortgage
Companies
Total
—2.26a
(0.70)
-0.10
(0.24)
-0.09
(0.27)
0.14
(0.27)
-0.13
(0.39)
-0.17
(0.24)
-0.011
(0.013)
0.19a
(0.07)
6.80a
(1.78)
0.024a
(0.005)
1.38a
(0.21)
-0.36
(0.24)
0.33
(0.27)
0.33
(0.31)
0.55b
(0.30)
1.12a
(0.50)
-0.46a
(0.17)
-0.94a
(0.20)
-0.11
(0.20)
-0.13
(0.28)
0.10
(0.17)
0.012
(0.009)
-0.03
(0.05)
0.42
(1.28)
0.11a
(0.003)
-0.03
(0.15)
-0.67a
(0.17)
-1.08a
(0.19)
-0.44b
(0.22)
-0.923
(0.21)
0.33
(0.26)
0.14
(0.09)
0.31a
(0.10)
0.07
(0.10)
0.20
(0.14)
-0.09
(0.09)
-0.004
(0.005)
-0.03
(0.03)
0.18
(0.65)
0.002
(0.002)
0.07
(0.08)
0.01
(0.09)
-0.19b
(0.10)
0.64a
(0.11)
0.22a
(0.11)
-3.66a
(1.66)
-0.46
(0.56)
-0.28
(0.65)
-0.24
(0.65)
-0.25
(0.92)
-0.07
(0.56)
0.018
(0.031)
0.21
(0.16)
4.17
(4.23)
0.03a
(0.01)
0.32
(0.49)
0.33
(0.58)
0.46
(0.64)
0.64
(0.74)
3.32a
(0.70)
-4.46a
(2.16)
-0.87
(0.73)
-1.00
(0.85)
-0.13
(0.85)
-0.31
(1.20)
-0.24
(0.73)
0.014
(0.041)
0.33
(0.21)
11.57a
(5.51)
0.07a
(0.02)
1.74a
(0.63)
-0.69
(0.75)
-0.49
(0.83)
1.17
(0.96)
3.l6a
(0.91)
0.67
0.45
0.48
0.39
0.56
a. Statistically significant at the 5 percent level.
b. Statistically significant at the 10 percent level.
NOTE: Dependent variable: num ber o f offices per 10,000 people in 1989- City intercepts reflect the difference between each o f the included
cities and Cleveland. Standard errors are in parentheses.
SOURCE: Author’s calculations.
reflect similar differences between middle- and
low-income neighborhoods and high-income
neighborhoods.
In all five cities, predominantly black areas
have significantly fewer commercial bank
offices per capita than predominantly white
areas. Differences range from more than 2.50
offices per 10,000 people in Atlanta to 0.85
offices in Cleveland and are statistically signifi
cant in all cases except Boston. Similar, though
less significant, differences show up across
income groups as well. The number of thrift
offices per capita is also related to both race and
http://fraser.stlouisfed.org/
income. In all cases, the thrift differences are
Federal Reserve Bank of St. Louis
more statistically significant than the commercial
bank differences, although the magnitude of the
former is larger only for Boston, Cleveland, and
Philadelphia. One explanation for this finding is
that the thrift regressions have a better overall fit
(R 1 ), reflecting a more consistent relationship
between income/race and office location.
Clearly, conclusions drawn from simple regres
sions such as these can be misleading. Black and
low-income areas may be less desirable to finan
cial institutions not because of race or income
per se, but because of other factors that are cor
related with race and income, such as housing
values and business employment. Moreover,
EB
TABLE
6
Factors Affecting the Change in
Financial Intermediaries’ Service
between 1977 and 1989
Intercept
10%- 50% black
Above 50% black
$20,000-$30,000 income
Below $20,000 income
Center city
White collar (%)
Home value ($10,000)
Housing units per capita
Firms per 10,000 people
Employees per capita
Boston
Detroit
Philadelphia
Atlanta
R2
Commercial
Banks
Thrift
Institutions
Check
Cashing
Companies
Loan and
Mortgage
Companies
-1.18a
(0.58)
-0.08
(0.19)
-0.14
(0.23)
-0.04
(0.23)
-0.09
(0.32)
-0.24
(0.20)
-0.017
(0.010)
0.10b
(0.06)
3.79a
(1.47)
0.0153
(0.004)
0.16
(0.17)
-0.21
(0.20)
0.25
(0.22)
0.49b
(0.26)
0.42
(0.24)
1.04a
(0.46)
-0.13
(0.16)
-0.54a
(0.18)
0.12
(0.18)
0.45b
(0.26)
-0.09
(0.16)
0.0l6b
(0.009)
-0.07
(0.05)
-2.96a
(1.18)
0.004
(0.003)
0.07
(0.14)
-0.90a
(0.16)
-0.38a
(0.18)
-0.32
(0.21)
-0.33
(0.20)
0.31
(0.22)
0.l4b
(0.07)
0.20a
(0.08)
0.09
(0.08)
0.08
(0.12)
-0.02
(0.07)
-0.0004
(0.004)
-0.04b
(0.02)
0.25
(0.55)
0.0003
(0.002)
0.01
(0.08)
-0.11
(0.08)
-0.19
(0.10)
0.42a
(0.10)
0.27a
(0.09)
-2.28
(1.57)
-0.13
(0.53)
-0.03
(0.62)
0.20
(0.61)
0.48
(0.87)
0.52
(0.53)
0.011
(0.030)
0.35a
(0.15)
-0.82
(4.00)
-0.008
(0.011)
-0.87b
(0.46)
0.95b
(0.55)
0.74
(0.60)
0.40
(0.70)
l.l4 b
(0.67)
-2.11
(1.68)
-0.20
(0.57)
-0.51
(0.66)
0.37
(0.66)
0.93
(0.93)
0.17
(0.57)
0.010
(0.032)
0.34a
(0.16)
-0.23
(4.28)
0.011
(0.012)
-0.55
(0.49)
- 0.16
(0.59)
0.50
(0.65)
0.99
(0.75)
1.50a
(0.71)
0.32
0.19
0.41
0.13
0.13
Total
a. Statistically significant at the 5 percent level.
b. Statistically significant at the 10 percent level.
NOTE: Dependent variable: change in the num ber o f offices per 10,000 people, 1977—1989- City intercepts reflect the difference between
each o f the included cities and Cleveland. Standard errors are in parentheses.
SOURCE: Author’s calculations.
because income and race are themselves highly
correlated, it is difficult to determine which of
the two factors is more important in predicting
financial institution behavior. To address this
concern, I ran regressions for each institution
type controlling for median home values, per
capita number of owner-occupied homes, num
ber of firms and employees, percentage of
employed residents with white-collar jobs, and
dummy variables for race, income, center city
location, and each sample city. Results are pre
sented in table 5.
The estimated difference in commercial banks’
http://fraser.stlouisfed.org/
level of service resulting from neighborhood racial
Federal Reserve Bank of St. Louis
and income characteristics shrinks considerably
when other factors are controlled for: Home val
ues, employment, and the number of housing
units appear to be more important determinants.
By contrast, neighborhood racial composition
(but not income) is still a strong predictor of
thrift institution behavior. Except for check cash
ing offices in predominantly black areas, racial
and income characteristics do not appear to
play a significant role in the location of either
check cashing or mortgage and loan offices.
Similar conclusions emerge about the change
in the number of offices between 1977 and
1989 (table 6). Racial and income effects all
m
TABLE
7
City Differences in Commercial
Banks’ and Thrifts’ Level of
Service Due to Race and Income
Commercial banks
10%-50% black
Above 50% black
$20,000-$30,000 income
Below $20,000 income
R2
Thrift institutions
10%- 50% black
Above 50% black
$20,000 - $30,000 income
Below $20,000 income
R2
Atlanta
Boston
Cleveland
Detroit
Philadelphia
2.11
(1.45)
3.33
(2.20)
-0.31
(1.48)
-0.66
(1.91)
0.86
-0.15
(0.44)
0.05
(0.74)
0.14
(0.45)
-0.50
(0.68)
0.62
-0.65
(0.40)
-0.26
(0.46)
-0.04
(0.55)
-0.15
(0.76)
0.62
-0.60
(0.79)
-0.77
(0.81)
0.92
(0.73)
0.71
(0.89)
0.38
-0.58a
(0.32)
-0.49
(0.35)
0.51
(0.51)
0.80
(0.74)
0.64
0.31
(0.70)
0.67
(1.05)
0.46
(0.71)
1.21
(0.92)
0.70
-0.15
(0.40)
-0.89
(0.67)
-0.08
(0.41)
-0.40
(0.62)
0.24
-1.29b
(0.28)
—1.12b
(0.32)
-0.62
(0.38)
-0.38
(0.54)
0.84
-0.18
(0.33)
-0.13
(0.34)
0.22
(0.30)
0.15
(0.37)
0.42
-0.54a
(0.28)
-0.84b
(0.31)
0.18
(0.45)
-0.31
(0.64)
0.65
a. Statistically significant at the 10 percent level.
b. Statistically significant at the 5 percent level.
NOTE: Dependent variable: num ber o f offices per 10,000 people in 1989. Regressions are similar to those in table 5. Coefficients for vari
ables other than race and income are available u po n request. Standard errors are in parentheses.
SOURCE: Author’s calculations.
but disappear when other factors are con
trolled for in the commercial bank regression,
but thrift institutions appear to have signifi
cantly reduced their presence in predominantly
black areas. Surprisingly, ceteris paribus, the
number of thrift offices in low-income areas
seems to have expanded. These effects nearly
offset each other in low-income black areas;
thus, it is middle- and high-income black
neighborhoods that seem to have suffered the
greatest decline in service.
Finally, regressions similar to those presented
in table 5 were run for commercial banks and
thrifts at the individual city level (see table 7,
which reports only the coefficients for income
and race). Although few of these coefficients
are statistically significant (in part because of
the small sample sizes), they suggest that the
aggregate regressions may mask individual city
differences. For example, ceteris paribus, pre
dominantly black areas are served by compara
tively more offices in Atlanta than in Cleveland,
Detroit, and Philadelphia. The only statistically
http://fraser.stlouisfed.org/
significant effects are differences based on race
Federal Reserve Bank of St. Louis
for Cleveland and Philadelphia thrifts. In both
cases, integrated and predominantly black areas
are much less likely to be served by thrifts than
are predominantly white areas.9
IV. Conclusion
This study finds little evidence that commercialbank branch services in low-income and minority
neighborhoods have been disproportionately
reduced since 1977 in any of the five cities exam
ined. Changes in the per capita number of com
mercial bank offices between 1977 and 1989 differ
■
9 I also ran other regressions to test the robustness of the results
presented in this section. Changes in the level of services were fit as func
tions of the change in ZCAs’ racial composition and income levels. Racial
and income effects were represented by their 1977 and 1989 values and
as continuous variables. I also used additional control variables such as
the percentage of the population living below the poverty level, CACIconstructed indices reflecting the “purchasing potential” for saving and
borrowing, and age of the housing stock. In no case did these additions
or changes alter the conclusions reported in this section in any substan
tial way.
41
only slightly between predominantly black or lowincome ZCAs and those that are high-income or
predominantly white. Moreover, these differences
are not statistically significant and nearly disap
pear when other demographic factors such as
housing and employment are controlled for.
Evidence also suggests that once these other fac
tors are taken into account, the number of offices
in low-income and predominantly black neigh
borhoods is similar to that of other areas. This
finding holds both in the aggregate and, for the
most part, in the five cities individually.
The results also indicate that thrift institutions
have been more likely to close offices in predomi
nantly black (but not low-income) neighborhoods
during the past 15 years and that, currently, thrifts
are less likely to be located in these areas. The
aggregate results seem to be driven primarily by
the behavior of thrifts in Cleveland and Philadel
phia. Some of this effect may be traceable to the
fact that firms acquiring the branch networks of
failed savings and loans were more likely to shut
down inner-city offices than those in the suburbs.
But this does not explain why offices in minority
rather than low-income areas were closed.
Finally, evidence shows that check cashing
companies have been more likely to open offices
in predominantly black areas, and that once other
variables are controlled for, race and income
appear to play no significant role in the change in
loan and mortgage company office location.
It is interesting to note that despite claims that
deregulation would lead to fewer financial institu
tion offices overall, the number of branches of
each type of firm used in this study actually in
creased over the sample period. This finding is
true both in absolute and in per capita terms and
appears to hold for each of the cities studied, even
though their patterns of demographic and eco
nomic growth differ considerably. Thus, failure to
observe significant differential effects in lowincome and minority areas should be viewed in
light of the fact that some of the overall predictions
regarding deregulation may not have materialized.
O n the surface, these findings lend little sup
port to those who allege that the financial serv
ices industry has weakened its commitment to
low-income and minority areas over the past
decade and a half. However, caution should be
used in extrapolating too much from the results.
Sample sizes used here are comparatively small,
and the unit of analysis, ZCAs, is not ideal. Fur
thermore, there is enough evidence of hetero
geneity in the cities selected to suggest that the
results may not apply to other localities.
One should also bear in mind that office clos
ings
are not the only signal of management deci
sions to reduce service in an area. Office staffs
and hours can be cut back, and purchases of
higher-priced, more technologically advanced
equipment such as ATMs can be put on hold. In
deed, given the relatively low office-space
prices in many poor and minority neighbor
hoods, it may be quite possible for a financial in
stitution to run a scaled-down office on a
profitable basis even if demand has dropped off.
Thus, further research on the quality of serv
ice may be necessary before definitive conclu
sions can be drawn about the impact of changes
in the financial services industry on minorities
and the poor.
EH
References
Avery, Robert B. “Making Judgments about
Mortgage Lending Patterns,” Federal Reserve
Bank of Cleveland, Economic Commentary,
December 15, 1989______ , and Thomas M. Buynak. “Mortgage
Redlining: Some New Evidence,” Federal
Reserve Bank of Cleveland, Economic
Revieui, Summer 1981, pp. 18-32.
______ , and Glenn B. Canner. “Mortgage Red
lining: A Multicity Cross-Section Analysis,”
Board of Governors of the Federal Reserve
System, Working Paper, 1984.
Bradbury, Katharine L., Karl E. Case, and Con
stance R. Dunham. “Geographic Patterns of
Mortgage Lending in Boston, 1982-1987,”
Federal Reserve Bank of Boston, New Eng
la n d Econom ic Review, September/October
1989, pp. 3-30.
Brobeck, Stephen, and Mark Cooper. “Eco
nomic Deregulation and the Least Affluent:
Consumer Protection Strategies,” in Con
sumer Closeups, Vol. 2. Ithaca, N.Y.: Cornell
University Press, 1991.
Canner, Glenn B., and Ellen Maland. “Basic
Banking,” Federal Reserve Bulletin, vol. 73,
no. 4 (April 1987), pp. 255-69.
Consolidated Analysis Centers, Inc. The Source
book o f Demographics a n d Buying Pow erfor
Every ZIP Code in the USA. Fairfax, Va.:
CACI, 1989.
Dennis, Warren L. “Brick-and-Mortar Branches
in the New Financial Services Era,” Am erican
Banker, September 11, 1984, p. 5.
Mitchell, Jeremy. Access to Basic B anking Serv
ices: The Problems o f Low-Income Am erican
Consumers. Rhode Island Consumers Coun
cil, 1990.
Scott, Charlotte H. “Low-Income Banking Needs
and Services,”Jo u rn a l o f Retail Banking, vol.
10, no. 3 (Fall 1988), pp. 32-40.
g
Price Stability
Conference Proceedings Offered
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discussed at a conference on
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on November 9 -1 0 ,1 9 9 0 . The
purpose of the conference was
■ The Welfare Costs
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A Dynamic Analysis
to encourage research and discussion on the costs and benefits
of adopting a policy to achieve
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Comments: Roland Benabou
and Randall Wright
■ Seigniorage as a
Tax: A Quantitative
Evaluation
■ Optimal Fiscal and
Monetary Policy: Some
Recent Results
by Ayse Imrohoroglu
and Edward C. Prescott
by V.V. Chari,
Lawrence J. Christiano,
and Patrick J. Kehoe
Comments: Stephen G. Cecchetti
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Comments: B. Douglas Bernheim
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by David Altig
and Charles T. Carlstrom
Panel Discussion on
Monetary Policy: What
Should the Fed Do?
■ The Goal of Price
Stability: The Debate
in Canada
Comments: Alan J. Auerbach
and Finn E. Kydland
by C. Freedman
■ The Sustainability
of Budget Deficits with
Lump-Sum and with
Income-Based Taxation
■ An Error-Correction
Mechanism for LongRun Price Stability
by Henning Bohn
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Comments: Timothy S. Fuerst
and James D. Hamilton
■ How Should LongTerm Monetary Policy
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by Lawrence Summers
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