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ECONOMIC REVIEW Additional copies of the ECONOMIC REVIEW may be obtained from the Research Department, Federal Reserve Bank of Cleveland, P. O. Box 6387, Cleveland, Ohio 44101. Permission is granted to reproduce any material in this publication providing credit is given. N O V E M B E R -D E C E M B E R 1971 PERFORMANCE OF RURAL BANKS AND CHANGES IN BANK STRUCTURE IN OHIO R ichard L. Gady A considerable am ount o f discussion has been focused on the type o f banking structure th a t w ould be the most appropriate to fa cilita te an ample flo w o f bank credit to the rural sector of the economy. Arguments have been advanced to the e ffe ct th a t branch banks or subsidiary banks o f m ulti-bank holding companies are p o te n tia lly in a better p o sition to provide an im proved flo w o f cre d it to the rural sector because they are often able to make larger individual loans and have access to more highly specialized personnel. Furtherm ore, branch or group banking systems IN THIS ISSUE are better able to s h ift funds to com m unities facing greater credit needs additional Performance o f Rural Banks and Changes in Bank Structure in O h io ......... 3 Inventory Investment and Economic A c tiv ity . . . .17 Annual Index ..................... 27 or funds to tap than national small money markets fo r u n it banks. Others have suggested th a t branch or holding company banking systems 1 Individual loan limits of National and State banks in Ohio are generally restricted to 10 percent of capital and surplus. For a small bank, this restriction can severely limit the bank’s effectiveness in servicing large loans. 2 See Emanuel Melichar and Raymond J. Doll, Capital and Credit Requirements o f A griculture, and Proposals to Increase A v a ila b ility o f Bank Credit, Report to the Steering Committee for the Fundamental Reappraisal of the Discount Mechanism, (Washington, D. C.: Board of Governors of the Federal Reserve System, November 1969). 3 ECONOMIC REVIEW m ight not increase lending in rural areas. Branch bank systems sometimes lose close personal IMPORTANCE OF AG RICULTURE IN OHIO contact w ith the local com m u n ity. A d d itio n a lly , it Ohio's agricultural sector makes a significant has been asserted th a t funds are lik e ly to be c o n trib u tio n to the overall economy o f the state. shifted o u t o f rural areas to larger cities where the In 1970, Ohio farmers received an estimated $1.6 head office or lead bank is located and where a o higher rate o f return on loanable funds may exist. b illio n in products gross and receipts spent fro m nearly sales o f $1.2 b illio n farm fo r Questions relating to the flo w o f bank credit to production inputs. During the past decade, gross the rural sector are im p o rta n t in Ohio because farm income has increased 32 percent w hile farm agriculture is a major industry in the State and the production expenses rose almost 35 percent. More structure o f banking has been undergoing change. significantly, gross receipts per farm increased over A cquisitions holding $6,000 ($7,978 to $14,050) during the decade, companies have recently been occurring at a rapid b u t realized net income per farm rose o n ly about of banks by m ulti-bank pace, and " w ith in c o u n ty ” bank merger a c tivity $1,400 has remained strong. This study was undertaken in substantial $4,670 increase in production expenses an a tte m p t to provide some additional in fo rm a tio n per farm. ($2,099 to $3,502) as a result o f a about the effects o f changes in bank structure in The rapid grow th in farm production expenses non-m etropolitan areas o f Ohio on the flow s o f has caused a greater reliance by farmers on debt bank credit. financing and heavy credit demands on the in sti indicate th a t "w ith in tutions th a t finance this debt, such as commercial c o u n t y " changes in bank stru ctu re in O h io did not Results o f the study banks, the Farm C redit System, and life insurance significantly alter the flo w o f bank funds to rural companies. The volume o f farm debt outstanding areas. Compared w ith other banks, those th a t at major lending in stitu tio n s in Ohio increased underwent a change in ownership experienced a from $511 m illio n in January 1961 to over $985 overall m illio n in January 1971. It is expected th a t the lending to farmers, b ut th e ir overall aggressiveness demand fo r farm cre d it w ill continue to increase at slight—bu t not significant—decline in in providing credit to local com m unities remained a fast pace.4 In addition, the demand fo r credit by essentially unchanged. The type o f flo w o f funds "agri-business" between banks was significantly altered at banks customers and th e ir own operations should remain changing ownership, but the d is trib u tio n o f the strong. flo w between rural banks and large c ity banks firm s to finance th e ir farm Commercial banks have played a major, though appeared to remain the same. declining, role in financing agriculture in Ohio, as 3 in the U nited States. Between 1960-1970, bank For a more detailed discussion of this issue, see John A. Hopkin and Thomas L. Frey, "Problems Faced by Commercial Banks of Illinois in Meeting the Financing Requirements of a Dynamic Agriculture," A g ricu ltu re Econom ic Research R eport 99, (Urbana, Illinois: Uni versity of Illinois, April 1969) and Robert J. Lawrence, The Performance o f Bank H olding Companies, (Wash ington, D. C.: Board of Governors of the Federal Reserve System, June 1967). 4 loans to farmers in Ohio were up by a 6.1 percent average annual rate, b u t slipped from 44.5 percent to 41.7 percent o f to ta l loans to farmers o u t standing at m ajor lending in stitu tio n s (Table I). 4 Melichar and Doll, Capital and Credit Requirements o f Agriculture. N O V E M B E R -D E C E M B E R 1971 TA B LE I Agricultural Loans Outstanding at Major Lending In stitu tion s in Ohio January 1, 1961 Lending Institution Volume Commercial banks Farm Credit System Production Credit Association Federal Land Banks Federal Intermediate Credit Banks Banks for Cooperatives* $227,144 Farm Credit System Total Farmers Home Administrationt Life Insurance Companies Total January 1, 1971 Percent of Total 44.5% $410,773 79,308 87,333 15.5 17.1 177,901 215,252 2,017 17,886 186,544 14,063 82,780 0.4 3.5 36.5 1,771 38,681 433,605 37,523 103,864 2.8 16.2 100 .0 % $510,531 Percent of Total Volume 41.7% 18.0 21.8 0.2 3.9 44.0 3.8 10.5 $985,765 1 0 0 .0 % * Loans outstanding to farmer-owned cooperatives, t Loans outstanding for farm ownership and farm operating expenses. Source: American Bankers Association Much o f this decline reflects the d iffic u lty o f rural mergers—were considered in this study o f “ w ith in banks in adapting to the changing credit needs o f c o u n ty ” farmers. areas. S pecifically, farm consolidation and bank performance in non-m etropolitan specialization resulting from rapid technological Bank Holding Companies. The p ro life ra tio n o f changes have caused a demand fo r large loans m ulti-bank holding com pany a c tiv ity in Ohio is a serviced by agricultural specialists. In many areas, relatively recent phenomenon. deposit grow th outstripped by at rural u n it banks has been an even larger grow th in the demand fo r farm loans. This fact, combined w ith m ulti-bank holding company was continuously active in the State p rio r to m ulti-bank O nly one large 1965. Four other holding companies w ith over $100 restrictions on individual loan size at many o f the m illio n deposits were form ed in 1958, 1966, 1968, smaller banks, has given the highly specialized and 1970. However, the second subsidiary bank Farm Credit System a com petitive edge in many (other areas. company was n o t purchased u n til 1965, 1967, than the lead bank) o f each holding HO LDING COMPANY AND MERGER A C T IV IT Y IN OHIO seven m ulti-bank companies w ith 55 subsidiary 1968, and 1970, respectively. In 1970, there were banks. Table II shows the trend o f acquisitions in The commercial banking system in Ohio, as in many a Because a bank acquired by a bank holding structural change as a result o f bank mergers, company retains its id e n tity and fre q u e n tly is not branching, and bank holding company activities. 5 Tw o other types m ulti-bank states, of has a ctivity holding been affecting company undergoing Ohio between 1955 and 1970. structure— acquisitions and See “ Registered Bank Holding Company Activity in Ohio, 1964-1969,” Econom ic Review, Federal Reserve Bank of Cleveland, September 1970. 5 ECONOMIC REVIEW T A B LE II mately 124 bank mergers in 50 o f the 88 counties Registered M ulti-B ank H olding Company A cquisitions and Bank Mergers Consummated in Ohio 1955-1970 number o f bank Total Acquisitions Year 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 Total Mergers 2 3 2 3 5 18 occurred Acquisitions Mergers in Nonin NonMetropolitan Metropolitan Areas Areas 10 10 7 10 17 6 11 13 13 4 11 5 6 6 5 7 2 in Ohio were consummated. Table II shows the 1 2 2 2 2 4 16 7 5 3 6 9 3 10 7 5 2 10 1 5 4 5 7 Source: Federal Reserve Bank of Cleveland in mergers, by year, th a t have Ohio during this period and also indicates those mergers th a t have occurred in non-m etropolitan areas. In a merger, the smaller bank usually assumes the id e n tity o f the larger bank, and the relationship between the tw o facilities is fre q u e n tly set up on more o f a head office-branch o ffice basis. Because o f the more complete fusing o f management th a t occurs when banks merge, behavioral adjustments o f merged banks can be expected to occur more rapidly than w ith holding company affiliates. M ETHODOLOGY Banks included in the sample fo r this study were selected on the basis o f tw o crite ria : (1) the holding company acquisition or the merger to o k place in a predom inately rural c o u n ty and (2) no immediate changes in management, other holding company acquisitions or mergers changes in the performance o f new ly acquired occurred in the co u n ty w ith in three years p rio r to subject to banks w ould seem like ly to occur slowly. There or after the change in the sample bank's structure. fore, the short period o f tim e th a t has elapsed The year 1967 was used as a c u to ff to perm it tim e since some o f the acquisitions in Ohio lim its the fo r observations th a t can be made on im plem entation Twenty-one of holding changes in bank lending practices, or the im plem entation process itself. Bank Mergers. Bank mergers in Ohio have been more numerous and more evenly distributed over observation above bank com pany tw o after the ownership change. mergers and five m ulti-bank acquisitions, w hich requirements, occurred m et the in Ohio between 1960 and 1967. A ll o f these were selected fo r analysis in this study. tim e than have bank holding company acquisi End-of-year call reports (subm itted to regu tions. Ohio banking laws stipulate th a t the banks latory agencies by banks) were used as the source involved in a merger must be located w ith in the o f data on the banks' performance. Data were same co u n ty; thus, statewide branching is pro collected fo r the December p rio r to the year o f the h ib ite d.6 During the 1955-1967 period, a pproxi bank merger or holding company acquisition and fo r December o f the year three years fo llo w in g the bank merger or holding company acquisition. In In some cases, a bank in Ohio may be permitted to branch in more than one county if its head office is located in a city which extends into two or more counties. 6 the case o f bank mergers, data fo r the tw o banks prio r to the merger were combined. Data, o f N O V E M B E R -D E C E M B E R 1971 course, were available fo r only one in s titu tio n changes in after the merger. could also influence the banks' performance. To ownership. Other factors, however, Twelve performance measures were calculated determine the exte n t o f these other influences, the to detect differences in performance th a t may sample banks were classified as to : (1) type o f have occurred in the merged and acquired banks change in corporate structure—holding company compared w ith other banks in th e ir respective acquisition or merger, (2) size o f bank—greater or counties during the three-year analysis period. It less than $15 m illio n in deposits at the tim e o f was acquisition,7 (3) date o f a change—before or after assumed th a t the co u n ty represents the relevant com petitive m arket o f the bank under December 1964, and (4) percent agricultural loans going a change in corporate structure. A lthough o f to ta l loans—greater o r less than 14 percent. the These comparisons should show possible effects o f banking markets of many of the larger m etropolitan areas encompass an area larger than a single cou nty, the banks in the study are located the other factors on bank performance. It should be emphasized, however, th a t there only in non-m etropolitan counties. The county, are other factors th a t could therefore, should serve as a close approxim ation o f underestimation o f the significance o f the changes. have caused the the relevant com petitive market fo r these banks. In the case o f bank mergers, there were several The study's analytical fram ew ork required the instances in w hich a relatively large bank merged comparison o f the sample banks w ith all other w ith a very small bank. Since data were available banks in their respective counties to m inim ize the o n ly fo r one bank after the merger, data fo r both possible effects o f changes in the overall demand banks were combined fo r the "b e fo re merger” fo r bank loans, deposits, and other services on a observation. A ny variations in the smaller bank's given performance measure. Variations in local behavior as a result o f the merger could have been economic conditions w ould presumably affect the p a rtia lly disguised in the aggregate. Furtherm ore, acquired bank and its com petitors in a sim ilar as indicated earlier, changes in banks acquired by manner. For example, an increase (decline) in loan holding companies often occur slow ly; three years demand or deposits resulting from the opening m ight not, therefore, be a s u fficie n t period o f tim e (closing) o f a large industry in a co u n ty w ould to id e n tify all o f the changes th a t eventually result have from a new ownership structure. a beneficial on many a bank's The twelve measures o f bank performance can changes in performance relative to other banks in be classified in to three groups. (They are discussed surrounding banks. (adverse) By effect considering the same county, a change in local conditions in more detail in the fo llo w in g three sections o f w ould be less like ly to bias the changes at the this article.) The firs t group o f measures (A) was sample banks. included as indicators o f a change in emphasis, if A statistical " t-te s t" was used in the study th a t any, placed on agricultural lending as a result o f assumes an actual difference, if any, between the new management attitudes tow ard the risk and performance o f the banks th a t underwent a change p ro fita b ility o f agricultural loans at the sample in th e ir corporate structure, compared w ith other banks in relation to other banks in th e ir immediate banks in the same counties, can be a ttrib u te d to the fact th a t the one group o f banks underwent 7Size of the purchased bank in the case of a merger. 7 ECONOMIC REVIEW m arket area. The second group o f measures (B) groups o f banks is significant in a statistical sense. O served as proxies fo r changes in the aggressiveness W hile the to ta l volum e o f farm loans during the o f management at the sample banks in providing observation periods generally increased at both additional bank cred it in th e ir local com m unities. groups o f banks, the ratio o f farm loans at the The th ird group (C) was included to measure sample banks to farm loans at banks th a t were not changes in the flo w o f funds between banks (in involved in a change in ownership (A1) declined most cases in this study, flow s between larger c ity from an average o f .72 to an average o f .64 (Table banks and rural banks) because o f a change in the III). This decline, however, was n o t characteristic corporate structure o f the bank. o f all the banks involved in mergers or holding company acquisitions; one-half o f the FARM LENDING PRACTICES Four performance in thirteen counties, or number covered, the acquired banks experienced an increase in to ta l agricultural measures were used to measure changes in emphasis on farm lending: A 1 —The ratio o f farm loans at sample banks to the to ta l o f farm loans at all other banks in the same county. A 2 —Ratio o f farm loans to total loans.Ratio fo r sample bank was compared w ith the average o f the same ratio fo r all other banks in the same county. lending compared w ith other banks in the county. A relatively large decline at a few banks appeared to account fo r the slight overall decline in farm lending th a t occurred. The decline also appeared to be more pronounced at banks acquired by holding companies than at merging banks and at larger banks acquired later in the period, although the differences were n o t statistically significant (see Appendix Table I).9 Farm loans declined relative to to ta l loans at A 3 —Ratio o f farm real estate loans to real estate loans. Ratio fo r sample was compared w ith average o f the ratio fo r all other banks in the total bank same same both the sample banks and the other banks in the study (R atio A 2 ), b u t the decline, w hich was concentrated in farm real estate loans, appeared to be county. slig h tly more apparent at the merged or acquired banks. Farm production loans relative to A 4 -R a tio o f farm nonreal estate loans to total nonreal estate loans. Ratio fo r sample bank was compared w ith the average o f the same ratio fo r all other banks in the same county. The results o f the phase o f the analysis indicate th a t banks undergoing changes in ownership structure experienced a slight reduction in farm lending, compared w ith com peting banks in their respective counties. A lthough this reduction is evidenced by each o f the above fo u r ratios, none o f the differences in farm lending between the tw o 8 to ta l nonreal estate loans (A4) declined nearly the O In this study, a result, as measured by the t-statistic, is considered "significant” if hypothesis being tested (that there is no change in performance between the sample banks and other banks in their respective counties) can be rejected at the 10 percent (or 5 percent) level of significance. In such a case, one can be 90 percent (or 95 percent) confident that the difference in performance between the two groups of banks was not the result of random variation. g A negative sign in Appendix Table I implies that a particular ratio increased at the acquired banks compared with other banks in their respective counties. A positive sign indicates the opposite occurrence. N O V E M B E R -D E C E M B E R 1971 T A B LE III Means o f Performance Measures at Sample Banks and Their Competitors Before and A fte r Ownership Change Sample Banks All Sample Banks Ratios* Holding Company Subsidiaries Merged Banks All Other Banks in County Before After Change Before After Change Before After Change Before After Change A1 —Farm loans at sample banks to the total farm loans at all other banks in the same county.t .718 A 2—Farm loans to total loans. .142 A3—Farm real estate loans to total real estate loans. .189 A 4—Farm nonreal estate loans to total nonreal estate loans. .108 B1—Total loans to total deposits. .541 B2—Commercial and industrial loans to total loans. .150 B3—Total deposits at the sample bank to total deposits of all other banks in the same county.t .660 B4—Time and savings deposits to total deposits. .516 B5—U. S. Government security holdings to total investments. .700 C1 —Demand deposits and other deposits of other banks to total deposits. .005 C2—Demand deposits and other deposits held with other banks to total deposits. .065 C3—Federal funds sold, repurchase agreements, and loans to other banks to total deposits. .003 .639 - .0 7 9 .125 -.0 1 7 .607 .150 .570 - .0 3 7 .142 - .0 0 8 1.074 .103 .717 -.3 6 7 .077 - .0 2 6 .127 .115 - .0 1 2 .177 - .0 1 2 .196 .190 - .0 0 6 .159 .123 - .0 3 6 .159 .156 - .0 0 3 .090 - .0 1 8 .587 .046 .121 .542 .102 - .0 1 9 .044 .586 .046 .538 .036 - .0 1 0 .591 .053 .113 .541 .096 - .0 1 7 .567 .026 .152 .002 .153 .144 - .0 0 9 .136 .187 .051 .142 .149 .007 .671 .011 .676 .688 .012 .444 .449 .005 .565 .049 .479 .536 .057 .674 .685 .011 .520 .572 .052 .609 -.0 9 1 .677 .632 - .0 4 5 .739 .505 - .2 3 4 .719 .600 .119 .002 - .0 0 3 .006 .002 - .0 0 4 .000 .000 .000 .001 .001 .000 .062 - .0 0 3 .065 .066 .001 .066 .045 -.0 2 1 .072 .059 - .0 1 3 .012 .004 .008 .004 .000 .023 .003 .016 .009 .023 .013 NOTE: Ranges of performance measures are shown in Appendix Table II. * Each county carries the same weight in the average, regardless of the volume of loans or deposits at banks in that county, t Ratios A1 and B3 are farm loans and deposits of the sample banks compared directly with total farm loans and deposits at all other banks in their respective counties. Source: Federal Reserve Bank of Cleveland same percentage at both the sample and other than at their com petitors (18.9 percent vs. 15.9 banks in the study, b ut large acquired banks and percent, respectively). The larger decline o f these banks loans at the acquired after 1964 placed a greater emphasis on these loans (A ppendix Table I). Prior merged or acquired banks could reflect an attem pt to boost other types o f loans to the merger or acquisition, the average ratio o f and become more closely aligned w ith com peting farm real estate loans to total real estate loans banks. (A3) was much higher at the banks th a t later changes were relatively small and n o t statistically underwent a change in th e ir corporate structure significant. Again, however, the differences in the 9 ECONOMIC REVIEW ratio was negative fo r all fo u r categories, and some INDIC A TIO N S OF AGGRESSIVENESS Five measures were included in the analysis to values were relatively large. This w ould im p ly th a t indicate changes in aggressiveness o f management the acquired banks became more aggressive in th e ir as a result o f an ownership change in providing overall lending policies as a result o f the ownership additional funds to local com m unities: change, although it is not know n how much o f the increase in loans resulted from loan participations B1—Ratio o f to tal loans to to ta l deposits. initiated by larger banks in m etropolitan areas. Ratio fo r sample bank was compared w ith The banks involved in ownership changes were, the average loan-deposit ratio fo r all other overall, also able to increase slightly th e ir share o f banks in the same county. total deposits in th e ir respective counties (B3), B2—Ratio o f commercial and industrial loans to to ta l loans. Ratio fo r sample bank although the t-values shown in A ppendix Table I was compared w ith the average o f the same ratio fo r all other banks in the same general. One-half o f the acquired banks did not are generally small and the change is certainly not hold th e ir share o f deposits (Table IV ). The banks county. th a t did n o t retain th e ir share o f deposits appeared B 3 -R a tio o f to tal deposits at the sample bank to total deposits o f all other banks in to the same county. (Appendix Table I). In contrast, the smaller banks the larger banks acquired after 1964 acquired earlier in the period were able to increase B4—Ratio o f tim e and savings deposits to slightly th e ir share o f to ta l deposits. tota l deposits. Ratio fo r sample banks was compared w ith the average o f the same ratio fo r all other banks in the same county. B5—Ratio holdings sample average banks in be The ratio o f business loans to to ta l loans (B2), somewhat surprisingly, rose less rapidly at the banks o f U. S. Government security to tota l investments. Ratio fo r bank was compared w ith the o f the same ratio fo r all other the same county. c h a n g in g ownership than at th e ir com petitors (Table III). The decline was sig n ifi cantly greater (statistically) at banks involved in m e rg e rs compared w ith th e ir com petitors. Conversely, banks acquired by holding companies showed an increase in the ratio o f business loans to The banks th a t underwent a merger or were purchased become by more holding companies appeared to aggressive according to tw o to ta l loans compared w ith other com peting banks. It is n o t clear w h y this difference in behavior occurred, b u t three explanations are plausible. measures—B1 and B3—when compared w ith other O f te n , banks in th e ir respective counties; b u t ratios B2 companies w ill in itia te large business loans and and aggressive participate in these loans w ith smaller affiliates. behavior by the banks changing ownership relative This w ould, o f course, increase the smaller banks' to th e ir com petitors. holding B5 indicated somewhat less lead banks of m ulti-bank holding o f business loans. The reverse o f this to example can also occur. The smaller bank m ight, increase th e ir loan-deposit ratios (B1) relative to as a result o f the a ffilia tio n , in itia te a large loan in the ir com petitors (Table III). A lthough none o f excess o f its loan lim it and participate in this loan the relative changes is statistically significant, this w ith the lead bank o r other a ffilia te banks o f the Merged and acquired Digitized10 for FRASER banks were able N O V E M B E R -D E C E M B E R 1971 W ith respect to investments, both the sample T A B LE IV banks and th e ir com petitors substantially reduced D istrib ution o f Increases and Decreases in the Performance Ratios holdings o f government securities relative to total Number of Merged or Acquired Banks Ratio Ratio Increased Decreased Relative to Relative to Other Banks Other Banks Ratios investments during the three-year observation periods. Again, however, there was a large contrast between the behavior o f merged banks and those banks purchased by a bank holding company as measured by Ratio B5 (Table III). A lthough the A1 —Farm loans at sample banks to the total farm loans at all other banks in the same county. A 2—Farm loans to totalloans. A 3—Farm real estate loans to total real estate loans. A4—Farm nonreal estate loans to total nonreal estate loans. B1—Total loans to total deposits. B2—Commercial and industrial loans to total loans. B3—Total deposits at the sample bank to total deposits of all other banks in the same county. B4—Time and savings deposits to total deposits. B5—U. S. Government security holdings to total investments. C1—Demand deposits and other deposits of other banks to total deposits. C2—Demand deposits and other deposits held with other banks to total deposits. C3—Federal funds sold, repurchase agreements, and loans to other banks to total deposits. relative differences were not statistically signifi 13 14 13 12 12 13 cant, the ratio o f governm ent securities to total investments declined less at merged banks compared w ith th e ir com petitors, b u t declined much more at banks acquired by a bank holding 12 17 14 9 9 17 company compared w ith th e ir com petitors. In only one c o u n ty did a holding company a ffilia te reduce its holding o f government securities less than its com petitors. This w ould im p ly th a t holding com pany banks became somewhat more 13 13 aggressive in seeking m unicipal securities than their 15 11 com petitors. This means th a t a larger volume o f 14 12 bank credit could have been kept in the local co m m u n ity or the State in the fo rm o f state and 4 13 local securities, rather than being transferred else where. The opposite was true o f merged banks. 15 11 Tim e and savings deposits became p ro p o rtio n ately a more im p o rta n t source o f funds fo r both 4 13 the sample banks and th e ir com petitors. On average, these deposits increased less (although not Source: Federal Reserve Bank of Cleveland by a statistically significant amount) in relation to holding company. A lthough this same arrangement demand deposits at the sample banks than at th e ir could be made through correspondent banks, the com petitors. The tim in g o f the change in ow ner transaction w ould be more easily accomplished ship structure, however, appeared to have a sig n ifi through a holding company, w ith o u t fear o f losing cant im pact on the behavior o f the merged or bank. acquired banks. The ratio o f tim e and savings F inally, after a merger, the management o f the deposits to to ta l deposits (B4) at banks purchased resulting before a customer to bank the can other participating im plem ent changes rather 1965 increased compared w ith th e ir q u ickly. Thus, the central management o f merged com petitors (A ppendix Table I). This same ratio banks could have rechanneled funds in to more decreased sig n ifica n tly at banks purchased during profitable, consumer instalm ent loans. or after 1965. Much o f this divergence o f behavior, 11 ECONOMIC REVIEW however, stemmed from differences in the deposit additional funds to rural areas, according to the com positions o f the fo u r groups o f banks before measures used in this study. However, neither did the acquisitions occurred. For example, Ratio B4 funds appear to be shifted o u t o f rural areas. (observation before the banks were purchased) fo r A lthough the overall direction o f the flo w o f the group o f banks acquired before 1965 was 3.3 funds was n o t significantly altered, several sig n ifi percent below th a t o f th e ir com petitors (46.0 cant differences in the components o f this flo w percent compared w ith 49.3 percent). In contrast, were detected. A this ratio fo r the group o f banks purchased during underwent a merger reduced the ratio o f th e ir or after 1965 was 4.2 percent above th a t o f th e ir holdings com petitors (60.9 respectively). the o f deposits o f other banks to to ta l 56.7 percent, deposits (C1) compared w ith th e ir com petitors d iffe re n tia l changes (Table III). This was especially true o f banks w ith percent and Thus, large m a jo rity o f banks th a t an aligning o f the deposit a smaller pro p o rtion o f agricultural loans in th e ir com position at the purchased banks w ith th a t o f p o rtfo lio . Banks acquired by holding companies, other banks in th e ir respective counties. on the other hand, slightly increased th e ir holdings probably reflected o f deposits o f other banks compared w ith th e ir FLOW OF FUNDS BETWEEN BANKS com petitors, but this difference was n o t statisti A th ird group o f ratios was adopted to observe the effects o f changes in bank structure on the flo w o f funds between banks: In contrast, the ratio o f deposit balances kept w ith other banks to to ta l deposits (C2) declined at C1—Ratio o f demand and other deposits o f other banks to to ta l deposits. Ratio fo r sample bank was compared w ith the average o f the same ratio fo r all other banks in the same county. C2—Ratio cally significant. o f demand and other deposits held w ith other banks to to ta l deposits. Ratio fo r sample bank was compared w ith the average o f the same ratio fo r all other both the sample banks and th e ir com petitors, but the decline was much larger at the sample banks' com petitors. Again, however, banks acquired by merger behaved d iffe re n tly than banks acquired by holding companies. Ratio C2 actually increased slightly at merged banks compared w ith a large decline at banks acquired by holding companies. This occurrence at merged banks was somewhat surprising banks in the same county. because it was th o u g h t th a t after C3—Ratio o f Federal funds sold, repurchase becoming in effect a single, larger in s titu tio n , these agreements, and loans to other banks to banks w ould have less need fo r correspondent tota l deposits. Ratio fo r sample bank was compared w ith the average o f the same services and participation loan arrangements. They ratio fo r all other banks in the same county. w ould, therefore, happen. The In general, the overall flo w o f funds between be in a position to reduce correspondent balances. A pparently, this did n o t banks results could became somewhat im p ly more th a t merged aggressive in banks was n ot significantly altered as a result o f seeking larger loans and retained the need fo r structural participation changes in ownership. Thus bank arrangements and correspondent mergers or holding com pany acquisitions did not balances. The relative decline o f deposits held w ith appear other banks at banks purchased by a m ulti-bank 12 to serve as a method of attracting NOVEMBER-DECEMBER 1971 holding company was expected. The lead bank o f the increase in flow s o f deposits to other banks the holding company is often able to supply many and the offsetting reduction o f Federal funds sold o f the services offered by correspondent banks, and loans to other banks. Hence, the ownership thereby reducing the need fo r these balances at change neither significantly improved nor lessened other banks. the overall flo w o f these interbank funds to rural An upward trend in the volume o f Federal funds sold, repurchase agreements, and loans to areas. CONCLUSION other banks at both the sample banks and th e ir In general, results o f this study indicate th a t com petitors was apparent from Ratio C3 (Table " w ith in c o u n ty ” changes in bank structure in Ohio H I). in Overall, the volume o f these funds, as a recent years, whether through a holding percentage o f to ta l deposits, increased significantly company acquisition or a merger o f tw o banks less at banks th a t underw ent a change in corporate w ith in the same co u n ty, did not m aterially alter structure the supply o f bank cre d it to rural areas. than at th e ir com petitors. This was especially true o f merging banks. A lthough the Statistical tests indicate th a t changes in agricul data show a larger increase in the volume o f these tural lending by banks th a t changed ownership funds at banks acquired by holding companies, the compared to other banks were n o t significant. increase was p rim a rily the result o f a large change However, there appeared to be a slight drop in at one sample bank. Thus, a significant m a jo rity o f loans to farmers at the merged and acquired banks banks compared th a t underw ent an ownership change w ith other banks. The banks that experienced a decline in sales o f Federal funds, experienced repurchase agreements, and loans to other banks, appeared to become somewhat more aggressive by compared w ith com peting banks. increasing th e ir loan-deposit ratios compared w ith a structural ownership change o f funds other banks, b u t evidence o f this overall aggres between banks, the sample banks—especially the siveness was not apparent in the other ratios. W ith respect to the overall flo w merged banks—tended to s h ift their emphasis from Banks acquired by m ulti-bank holding companies selling Federal funds and making loans to other appeared to increase the p ro p o rtion o f business banks to m aintaining demand and tim e deposits, loans to to ta l loans and to reduce holdings o f perhaps as correspondent balances, w ith United banks. other Furtherm ore, the acquired and merged States Government securities. Merged banks, on the other hand, significantly reduced the banks, relative to other banks in the respective pro p o rtion counties, reduced th e ir holdings o f balances o f compared w ith th e ir com petitors. The type o f other banks. The effect o f changes in banking flo w o f funds among banks was altered by the structure structural change, b u t the overall d ire ctio n o f the on the overall to ta l flo w o f funds, therefore, was apparently insignificant because o f of business loans to to ta l loans, flo w was essentially unchanged. 13 ECONOMIC REVIEW STATISTICAL APPENDIX Statistical Tests of Differences. Tests o f signifi i.e., the tw o sets o f banks came from d iffe re n t cance were performed to determine if the banks populations. For ratios A1 and B3, the t-test was undergoing used to test the null hypothesis: a change in corporate structure perform d iffe re n tly when compared w ith all other ratios except A1 and B3, a t-test was used to test kBB kB A ^kOB SkOA H banks in the ir counties. More specifically, fo r all ° ‘ = 0 where: the null hypothesis: k is a portfolio component rather than a ratio, k = 1, 2 H0 : (SiBB SiB A ) (SiOB SiO A ) 0 A where: significant t c o e fficie n t in this case w ould indicate th a t, w ith a given level o f certainty, the ratio o f the considered p o rtfo lio com ponent at the S- = Mean of ratio i at Bank before change in ownership, ID D i = 1 -1 0 banks changing ownership to other banks in the co u n ty was sig n ifica n tly d iffe re n t in the year SjgA = Mean of ratio i at Bank three years after change in ownership, i = 1 —10 before the change in ownership fro m three years S after the change. S com plem ent the t-test. This test is a nonparam etric iOB = Mean of ratio i at all other banks in the county before Bank's change in ownership, i = 1—10 iOA = Mean of ratio i at all other banks in the county after Bank's change in ownership, i = 1—10 A second test, the sign test, was used to test o f differences between means on the basis of the number o f banks experiencing a change in a A significant t co e fficie n t w ould indicate that, at given d irection. The t-test can be greatly affected th a t level o f significance, the banks undergoing a by a large change at one or tw o banks or counties ch a n g e in the sample. The sign test, w hich weights all the in c o rp o ra te structure perform ed d iffe re n tly during the three years after the change changes than the other banks in th e ir respective counties; influenced by a few large changes. 14 equally, w ould not be as strongly N O V E M B E R -D E C E M B E R 1971 APP E N D IX T A B LE I Tests o f Significance o f Change in Various Performance Ratios as A ffected by a Change in Bank Structure Classed According to Structure Change Ratios Overall t Values* Classed According to Date of Change Holding Before Merger Company 1965 A1 —Farm loans at sample banks to the total farm loans at all other banks in the same county. 1.28 0.35 1.33 A 2—Farm loans to total loans. - 0 .0 7 -0 .0 1 0.10 A 3—Farm real estate loans to total real estate loans. 0.58 0.27 0.81 A 4—Farm nonreal estate loans to total nonreal estate loans. 0.25 0.24 0.07 B1—Total loans to total deposits. - 1 .0 7 - 0 .6 0 - 0 .9 7 B2—Commercial and industrial loans to total loans. 0.36 1.89#* *-0 .7 8 B3—Total deposits at the sample bank to total deposits of all other banks in the same county. -0 .1 5 - 0 .1 4 - 0 .1 8 B4—Time and savings deposits to total deposits. 0.35 0.13 0.39 B5—U. S. Government security holdings to total investments. -0 .7 7 - 1 .5 9 1.54 C1—Demand deposits and other deposits of other banks to total deposits. 1 .1 7 ** 1 .2 4 ** - 1 .0 0 C2—Demand deposits and other deposits held with other banks to total deposits. -1.33 - 1 .6 2 0.69 C3—Federal funds sold, repurchase agreements, and loans to other banks to total deposits. 1 .3 1 ** 2 .2 9 # * *-0 .7 2 Classed According to Bank Sizet Classed According to Percent Agricultural Loans in Portfolio! 1965 and After Small Large - 0 .8 3 0.14 1.82 - 0 .1 4 0.73 - 0 .3 4 1.23 - 1 .0 2 0.47 - 0 .8 8 1.19 - 0 .2 0 0.35 0.50 0.37 0.77 0.28 0.53 0.99 - 0 .5 3 - 1 .0 8 - 0 .9 7 1.45 - 0 .9 9 - 1 .1 5 -0 .4 1 0.39 - 0 .7 2 0.02 —0 77 1.13 0.12 - 0 .1 5 1.42 1.48 - 0 10 - 0 .7 9 1.05 - 1 .0 2 1.46 - 0 .1 4 - 0 03 - 2 .4 6 § 2.32 § -0 .6 6 1.14 0.52 - 0 19 0 23 1 21 Less Than 14 Percent 14 Percent and Over - 0 .2 8 - 0 .7 7 - 0 .7 9 - 0 .1 7 0.10 0.63 1.05 0.94 1.79# 0 89 0.14 -2 .2 0 # - 0 .0 7 - 1 .6 9 —2.28§ 0 59 0.97 0.87 0.19 1 .4 2 ** 1 .4 8 ** 0.24 2.13 1.75 2.26 1.83 2.20 1.80 2.16 1.77 2.18 1.78 2.18 1.78 Critical Values 5% 10% ± 2.06 ± 1.71 2.09 1.73 2.78 2.13 * A negative sign implies that a particular ratio increased at the acquired bank compared with other banks in their respective counties. A positive sign indicates the opposite occurrence, t Small: $15 million deposits or less before structure change; large: more than $15.1 million deposits before structure change. X Classed according to distribution of loan portfolio before structure change. § Significant at the 5 percent level of probability. #Significant at the 10 percent level of probability. f * The sign test was significant at the 5 percent level of probability for the occurrence of increases or decreases associated with these ratios. Source: Federal Reserve Bank of Cleveland ECONOMIC REVIEW APPEND IX T A B L E II Range o f Performance Measures at Sample Banks and Their Com petitors Before and A fte r Ownership Change Sample Banks Holding Company Acquisitions Merged Banks Ratios A1 —Farm loans at sample banks to the total farm loans at all other banks in the same county. A2—Farm loans to total loans. A 3—Farm real estate loans to total real estate loans. A4—Farm nonreal estate loans to total nonreal estate loans. B1—Total loans to total deposits. B2— Commercial and industrial loans to total loans. B3—Total deposits at the sample bank to total deposits of all other banks in the same county. B4—Time and savings deposits to total deposits. B5—U. S. Government security holdings to total investments. C1—Demand deposits and other deposits of other banks to total deposits. C2—Demand deposits and other deposits held with other banks to total deposits. C3—Federal funds sold, repurchase agreements, and loans to other banks to total deposits. Before After Before After .03 - 2.58 .01 .35 .09 - 2.76 .01 .46 .10 - 2.07 . 0 3 - .15 .09 - 1.48 .02 .11 .01 - .34 .01 - .32 .01 - .45 .01 - .61 .05 - .26 .04 - .22 .01 - .44 .01 - .44 .01 .36 - .31 .70 .00 .42 - .28 .71 .00 .40 - .13 .65 .01 .47 - .10 .73 .00 - .34 .43 - .67 .00 - .31 .41 - .71 .05 - .29 .0 0 - .29 .05 - .18 .1 3 - .29 .09 - .27 .08 - .32 Before After .14 - 2.04 .12 - 1.95 .05 - 1.08 .1 3 - .99 .17 - .67 .28 - .77 .57 - .78 .6 4 - .79 .23 - .71 .26 - .74 .38 - .91 .27 - .93 .61 - .94 .21 - .63 .55 - .89 .35 - .93 .0 0 - .07 .00 - .01 .00 - .00 .00 - .01 .00 - .01 .00 - .01 .01 - .10 .02 - .13 .04 - .10 .01 - .09 .02 - .12 .02 - .13 .0 0 - .07 .00 - .09 .00 - .00 .0 0 - .09 .00 - .02 .00 - .06 Source: Federal Reserve Bank of Cleveland 16 All Other Banks in County N O V E M B E R -D E C E M B E R 1971 INVENTORY INVESTMENT AND ECONOMIC ACTIVITY James L. Pate Business inventory investment is one o f the most volatile components o f to ta l spending. As a BUSINESS IN V EN TO R IES AND IN V E N TO R Y BEHAVIOR result, fluctuatio ns in business inventories have an Q uarterly data on business inventories are based im portant influence on overall economic activity. largely on the book values (generally valued at The purposes o f this article are to describe the cost) o f stocks held at the end o f a period by various inventory concepts and to review the manufacturers, typical behavior patterns o f inventory investment salers.2 during economic contractions and expansions and fluctuations The retailers, general in and merchant w hole patterns of grow th and business inventories during the the somewhat atypical behavior o f inventories in post-World War II period are illustrated in Chart 1. the most recent economic contraction and the The most notable aspects o f inventory behavior in current recovery. this S ignificantly, the behavior o f inventories was an period are m anufacturing the recurring inventories fro m flu ctu a tio n s 1948 to in 1961 im p ortant factor in both the moderate decline in and the rapid, but generally stable, grow th since o u tp u t during 1961, the economic co ntraction from November 1969 through November 1970 and in the sluggish recovery, now in in stocks, w hich usually accompanies an economic the inventory adjustm ent th a t occured during the 1966-1967 business slowdown. progress.1 The absence o f a sharp or prolonged reduction despite Five major periods o f inventory flu ctu a tio n s occurred during the 1948-1961 period, and fo u r of th e s e -1948-1949, 1953-1954, 1957-1958, and contraction, cushioned the recent decline in over 1960-1961—were associated w ith contractions and all a ctivity and apparently lessened the need fo r expansions in overall economic a ctivity. The fifth any substantial rebuilding o f inventories, which period o f inventory adjustment, w hich to o k place norm ally occurs during the early phase o f an economic recovery. 1 The National Bureau of Economic Research has desig nated November 1969 and November 1970 as the tentative beginning and ending of the latest economic contraction. N ational Bureau R eport Supplem ent No. 8, National Bureau of Economic Research, May 1971. 2 For a more complete and detailed definition of business inventories, see U. S. Department of Commerce, N ational Income, A Supplem ent to the Survey o f Current Business, 1954 edition, (Washington, D. C.: Government Printing Office, 1954), pp. 135-138, or U. S. Congress, Joint Economic Committee, 1967 Supplem ent to Econom ic Indicators, Joint Committee Print, (Washington, D. C.: Government Printing Office, 1967), pp. 76-84. 17 ECONOMIC REVIEW Chort 1. MANUFACTURING and TRADE INVENTORIES BO O K VALUE B illio ns of d o lla rs ■ RATIO SCALE 4 END OF QUARTER ________i_______ i_______ i_______ l_______ i_______ I_______________ i_______ i________i_______ ;_______________ i________________________________________I________i________i_______ i_______ l_______ 1_______ i________ 1948 Last entry: NOTE: '5 4 ’57 '6 0 ’63 ’6 6 '6 9 72 Shaded areas indicate periods of business contraction as defined by the National Bureau of Economic Research, Inc Source: in ’5) 20 71 U. S. Department of Commerce 1950-1951, contraction or was not associated expansion any tial number o f economic studies th at a ttem pt to in overall economic w ith id e n tify and explain so-called "in v e n to ry cycles” activity and extended beyond m anufacturing to or retail concept o f inventory cycles involves three essential and wholesale stocks. This widespread increase in inventories reflected the rising needs o f defense programs, the final phase o f a substantial stockpiling th a t began w ith the outbreak o f the Korean C o n flict, and some involuntary inventory accumulations consumer resulting spending from after a slowdown mid-1950. in Despite reductions in inventories during the second half o f 1951, stock-sales ratios fo r most consumer goods m anufacturing industries and many categories o f retailing were still higher at the end o f 1951 than the average level of the ratios during the 1948-1949 period. The historical v o la tility o f business inventories, especially in manufacturing, has led to a substan 18 "subcycles.” notions: The rationale underlying the 4 3 See, for example, L. A. Metzler, "The Nature and Stability of Inventory Cycles," Review o f Economic Statistics Vol. 23, No. 3 (August 1941),pp. 113-129; M. Abramovitz, Inventories and Business Cycles w ith Special Reference to M anufacturing Inventories (New York: National Bureau of Economic Research, 1950); Ruth A. Mack, "Notes on Subcycles in Theory and Practice," Am erican Economic Review Vol. 47, No. 2, (May 1957), pp. 161-174, and discussion by Edwin B. George, et. at., pp. 175-186; and L. M. Stanback, Jr., Postwar Cycles in M anufacturers' Inventories, (Princeton, New Jersey: National Bureau of Economic Research, 1961). 4 For a discussion of these ideas, see J. P. Lewis and R. C. Turner, Business Conditions Analysis, (2nd ed.; New York: McGraw-Hill Book Company, 1967), pp. 508-510. N O V E M B E R -D E C E M B E R 1971 1. Firms make buying and production decisions w ith an aim toward maintaining behavior and the inventory cycle,5 have focused on other determinants o f inventory investment a r e la t iv e ly c o n s ta n t or desired inventory-shipm ents (or sales) re lation ship. such as prices, interest rates, and expectations. The results o f the research are inconclusive.6 However, any reasonably satisfactory explanation o f inven to ry 2. In those industries where firm s make sales behavior must groups distinguish between p rim arily o u t o f finished inventories, production lags behind sales in such a way th a t unexpected increases in sales are c a tio n -fin is h e d lim ited by the availability o f inventories. materials and supplies—and give recognition to the wholesale, and of firs t d iffe re n t inventories—manufacturing, re ta il—and the stages o f fa b ri goods, w o rk in process, and d iffe re n t motives fo r holding inventories. 3. When a m ajority o f sellers have inven tories th a t are too high or to o low, simultaneous efforts to replenish or Some stocks are held fo r transactions purposes and are influenced p rim a rily by current sales. Also, some stocks are held fo r precautionary reasons—to reduce th e ir inventories w ill be partly self-defeating, because a concerted e ffo rt by firm s to rebuild (or liquidate) stocks w ill stim ulate (or reduce) sales o f the firm s supplying the inventories and, therefore, in the aggregate, cancel out part o f the progress tow ard reestablishing the desired relationship between inven tories and sales. Thus, according to guard this concept, once the place. A ll th a t is apparently required to set the inventory adjustm ent in m otion is a substantial disparity between actual and desired inventories. Such a disparity may be the result o f either a change in sales o r a revision in w hat a large number o f firm s consider to be a desirable inventory-sales relationship. The empirical evidence in support o f inventory c y c le s —p articularly p rio r to the 1960's—is extensive, but the concept does n o t provide a complete or entirely realistic basis fo r explaining the com plex behavior of inventories. Recent research studies, w h ile drawing on the findings o f some o f the earlier research on aggregate inventory of losing sales The research of L. A. Metzler, for example, remains as one of the classic theoretical articles on the subject of inventories. See Metzler, "Inventory Cycles." adjustment in inventory investment behavior takes unexpected possibilities 5 desired inventory-sales relationship is disturbed, an widespread against the For example, Klein found a positive relationship be tween inventory investment and changes in the price level and Lovell found a negative relationship. See L. R. Klein, "A Postwar Model: Descriptions and Applications," Models o f Income Determ ination, A Report of the National Bureau of Economic Research (Princeton, New Jersey: Princeton University Press, 1964), and M. Lovell, "Sales Anticipations, Planned Inventory Investment, and Realizations," Determ inants o f Investm ent Behavior, A Conference of the Universities—National Bureau for Economic Research, (New York: Columbia University Press, 1967). With respect to financial variables, Clark found some relationship between inventory investment and deviations in demand and time deposits from a linear trend. See Colin Clark, "A System of Equations Explain ing the United States Trade Cycle 1921 and 1941," Econometrica, Vol. 17, No. 2 (April 1949). Robinson found no statistically significant relationship between department store inventories and the rate of interest on prime commercial paper. See N. Y. Robinson, "The Acceleration Principle: Department Store Inventories, 1920-1956," Am erican Economic Review, Vol. 49 (June 1959), pp. 348-358. For a recent analysis of some of the major determinants of inventory investment, see Barry Bosworth, "Analyzing Inventory Investment," Brookings Papers on Econom ic A c tiv ity 2, (Washington, D. C.: The Brookings Institution, 1970), pp. 207-234. 19 ECONOMIC REVIEW Change in Business Inventories 1967-1970 (Billions o f Dollars, Seasonally Adjusted) Change in Book Va|ue Change jn All Other Book Value Inventory Change in Change in ± Nonfarm = Busin Nonfarm ± Valuation ± Farm Inventc Total Inventories Inventories Adjustment Inventories Change in Book Value of Manufacturing and Trade Inventories Year Manufacturing Retail 1967 1968 1969 1970 $4.7 6.1 6.5 3.7 $1.0 2.6 2.9 -0 - Wholesale $1.4 1.4 2.3 2.7 $ 7.1 10.1 11.7 6.4 $ 9.0 11.0 13.6 7.7 $1.9 1.0 2.0 1.3 - $ 1 .4 -4 .1 -6 .4 -5 .2 $0.7 0.1 0.1 0.3 $8.2 7.1 7.4 2.8 Sources: U. S. Department of Commerce and Federal Reserve Bank of Cleveland because o f inadequate stocks—and are m ainly and trade inventories to the book value o f other influenced by expected sales and errors in past nonfarm sales forecasts. F inally, it appears th a t some stocks contract construction, transportation, co m m uni are held fo r speculative reasons and are probably cations, and electrical, gas, and sanitary services). inventories (such as those in m ining, influenced by such factors as the prospects o f Further, the change in to ta l nonfarm inventories w ork stoppages and price changes.7 This is by no must be com puted by calculating the net increase means an exhaustive in flu e n c e inventory list o f factors th a t can decisions. The (or decrease) between the sum o f book values o f factors m anufacturing, trade, and other nonfarm inven mentioned appear to be the major variables th a t tories at the end o f one period and the end o f a have influenced inventory behavior in recent years previous period—usually expressed as an annual and thus have affected, to some extent, overall rate (see table). The most com plex step in the com putation o f economic a ctivity. business inventories involves reevaluation o f book CHANGE IN BUSINESS INVEN TO RIES To relate inventories to overall economic values o f nonfarm stocks. Changes in book values of nonfarm inventories must be increased or a ctivity, it is necessary to convert book values o f reduced by the am ount o f the "in v e n to ry valu inventories in to physical volume o f stocks valued ation at current and constant prices. Book values o f inadequate because, fo r example, the replacement stocks are generally based on accounting methods o f stocks as they are consumed may, and usually that are inappropriate fo r national income and are, made at prices q uite d iffe re n t fro m those o f adjustm ent” (IV A ). Book values are product accounts and must therefore be adjusted. the item removed fro m stock. As a result, book The firs t step in the com putation o f business values include changes in value th a t represent the inventories is to add the level o f m anufacturing difference between acquisition and replacement 7 For a somewhat different list of motives, see Robert Eisner and Robert H. Strotz, "Research Study Two: Determinants of Business Investment," Impacts o f Mone tary Policy, A Series of Research Studies prepared for The Commission on Money and Credit, (Englewood Cliffs, New Jersey: Prentice-Hall, 1963), pp. 105-108. 20 prices, as well as changes in the physical volume o f inventories. In effect, because the IV A measures the excess in the change in the physical volume o f nonfarm business inventories, valued at average prices during the period, over the change in the N O V E M B E R -D E C E M B E R 1971 book value o f nonfarm inventories, it excludes th a t Chart 2. part o f the change in book value o f stocks th a t IN VEN TO R Y VA LU A TIO N ADJUSTM ENTS occurred because o f changes in prices. This adjust B illio n s of d o lla r s m ent procedure is made to both corporate and unincorporated business p ro fits to remove the inventory p ro fit or loss th a t occurred in business B illio n s of d o lla rs Cj - - 1.0 2.0 accounting when the book cost o f goods removed N O N CO RPO RATE - 3 .0 from inventories differs from cost. The reason fo r this the replacement com plex series o f adjustments, w hich is made separately fo r a large CO R PO R A TE -4 .0 - 5.0 - 6.0 number o f industries, is th a t only the change in TO TA L ----- 1 IN V EN TO R Y V A LU A TIO N A D JU STM EN T nr physical volume o f stocks is counted as current o u tp u t in the estimates o f gross national product - 7 .0 Q (GNP). No valuation adjustment is required fo r 0 - 1.0 - 2.0 TO TA L M A N U FA C T U R IN G farm inventories because farm income, in contrast to corporate pro fits and income o f unincorporated -3 .0 enterprises, is measured exclusive o f inventory ULJ^ 0 profits. The result o f these steps is an estimate o f the - 1.0 - 2.0 -4 .0 m TO TA L W H O LE S A L E "change in business inventories," and it is this value th a t is entered in to the calculation o f the .................... level o f GNP. Positive changes in business inven TO TA L RETAIL 0 tories represent inventory investment and add to the level o f GNP; conversely, negative changes - 1.0 - 2.0 0 T=rU - 1.0 - 2.0 O TH ER* - ANNUALLY w ould tend to reduce GNP. C onceptually, the behavior o f the inventory 0 TP valuation adjustm ent is d ire ctly reflected in the calculations and resulting values o f the change in business inventories and changes in 1.0 - 2.0 inventory - 3 .0 investment. As illustrated in Chart 2, the size o f the IV A - C O R P O R A TE -4 .0 has tended to grow rapidly since the mid-1960's. For example, in 1969, more than $6 -5 .0 b illio n was subtracted fro m the book value of - SEASONALLY ADJUSTED inventories in determ ining the change in business ANNUAL RATE-QUARTERLY inventories. The IV A was about $1 b illio n lower in 1970 than in 1969, bu t still amounted to more o For a more complete description of the inventory valuation adjustment, see N ational Income, 1954 edition, 196 4 Last entry: ’6 5 1970; 66 '67 '6 8 6.0 - 7 .0 '6 9 '7 0 '71 20 1971 ^Includes mining, contract construction, transportation, communication, and electric, gos, and sanitary Source: services. U. S. Department of Commerce pp. 44 and 59. 21 ECONOMIC REVIEW than $5 b illio n . In 1970, reductions in the size of about one-third o f the to ta l rise in GNP. For the IV A occurred in manufacturing, wholesale, example, during the firs t tw o quarters fo llo w in g and retail levels. However, in the category termed the trough o f the 1960-1961 recession, inventory "o th e r” —w hich struction, includes m ining, contract con transportation, electric, gas, and com m unications, and sanitary services—the IV A continued to increase. investment rose $7.3 b illio n w hile GNP rose $20.6 b illio n . In fact, one study indicates th a t if 75 percent o f the flu ctu a tio n s in inventory invest ment could have been controlled, the economy The corporate com ponent o f IV A accounted fo r nearly 90 percent o f the to ta l and is the only w ould not have experienced the fo u r post-World War II recessions th a t occurred in 1948-1949, com ponent published on a quarterly basis. Thus, 1953-1954, the corporate IV A provides some insights in to relationships between changes in inventory invest recent developments. A lthough the corporate IV A ment and changes in GNP during the fo u r previous on a quarterly basis fluctuates considerably, the and the current post-war economic contractions general trend since 1969 indicates some possible and expansions are illustrated in Chart 3. 1957-1958, and 1960-1961.9 The fu rth e r reduction in the to ta l IV A fo r 1971. RECENT DEVELOPMENTS CHANGES IN IN V EN TO R Y INVESTM ENT AND ECONOMIC A C T IV IT Y The magnitude economic a c tiv ity of flu ctu a tio n s is fre q u e n tly in overall measured by The behavior o f inventory investment during the most recent recession and recovery is in marked contrast to the experiences o f the fo u r previous contractions and expansions. During the quarterly changes in gross national product. In this 1 9 6 9 -1 9 7 0 con text, it is neither the level o f the book values investment declined only $2.0 b illio n w hile GNP economic con tra ctio n , inventory o f inventories nor the change in business inven rose $40 b illio n . Furtherm ore, almost all o f the tories th a t is d ire ctly related to the behavior o f decline in inventory investment occurred during economic a ctivity. Rather, it is the difference in the firs t tw o quarters o f the contraction. On the inventory investment between tw o periods (or the other hand, during the fo u r contractions in overall change in the change in business inventories) th a t economic a c tiv ity p rio r to the 1969-1970 reces influences the change in GNP. sion, to ta l In general, inventory investment declines during economic contractions and rises during the early reductions averaged $7.1 in inventory b illio n , w hile investment GNP declined an average o f $4.3 b illio n . stages o f economic expansions. In each o f fo u r The same contrasts are apparent between the m ajor economic contractions between 1948 and current recovery and the early stages o f previous 1961, the decline in inventory investment exceeded the decline in GNP. For example, in the 1 9 6 0 -1 9 6 1 recession, inventory investment declined $7.4 b illio n w hile GNP declined $1.1 b illio n . During the firs t tw o quarters o f each o f the economic expansions between 1948 and 1961, increases in inventory investment accounted fo r 22 g See U. S., Congress, Joint Economic Committee, "An Econometric Analysis of the Postwar Relationship Be tween Inventory Fluctuations and Changes in Aggregate Economic Activity," by Lawrence E. Klein and Joel Popkin, printed for Joint Economic Committee in Inven to ry Fluctuations and Econom ic Stabilization, Part III, (Washinton, D. C.: Government Printing Office, 1961), pp. 71-86. N O V E M B E R -D E C E M B E R 1971 Chart 3. recoveries. During the firs t tw o quarters o f the CHANGES IN BUSINESS INVENTORY INVESTMENT AND GROSS NATIONAL PRODUCT DURING current expansion, the to ta l increase in inventory BUSINESS CONTRACTIONS AND EXPANSIONS investment amounted (compared w ith to o nly $2.0 b illio n an average o f $8.6 b illio n in previous recoveries and accounted fo r less than 4 percent o f the to ta l increase in GNP. U nlike previous recoveries) inventory investment actually declined during the firs t quarter fo llo w in g the trough o f the most recent contraction. The results o f the somewhat unusual behavior o f inventory investment during the most recent recession and the current recovery have been to cushion economic a c tiv ity during the contraction and to moderate the pace o f the economic expansion. The relatively moderate overall reduction in inventory investment, which reflected some increases in the tw o quarters preceding the low p o in t o f the recession, prevented a more severe contraction. In fact, the behavior o f inven to ry investment 1969-1970 moderate co ntributed contraction, recession in in the to making general, the post-World the most War II period. S im ila rly, the unusually small increase in inventory investment th a t has occurred so far during the recovery has contributed to the sluggish pace of the current expansion. The modest increase in inventory investment in recent months is, o f course, p a rtia lly due to the increases in inventory investment th a t occurred during the late stages o f the recent contraction and the generally 10 sluggish grow th o f business sales. In addition, P P+1 P+2 P+3 PEAK Last entry: 2Q 1971 Source: U. S. Department of T T+l TROUGH Commerce T+2 T+3 ^ F r o m the trough of the most recent contraction through the second quarter of 1971, total manufacturing and trade sales increased 8 percent, which is about in line with the average increase during comparable periods following the four previous recessions. However, the measurement of the rate of increase in business sales following the most recent recession is influenced by the depressed level of business sales in the fourth quarter of 1970, which partly reflected the effects of the work stoppage in the automotive industry. 23 ECONOMIC REVIEW the recent behavior of inventory investment appears to have also been influenced by other factors, including w o rk stoppages, anticipated w o rk stoppages, and price expectations. Chart 4. CHANGES IN M A N U FA C TU R IN G AND TRADE INVENTO RY IN VESTM EN T B O O K VA LU E Inventory Developments in Manufacturing and B illio n s o f d o lla r s B illio n s o f d o lla r s M A N U FA C TU R IN G Trade. The increases in inventory investment in the second and th ird quarters o f 1970, w hich were im p ortant factors cushioning the recent economic contraction, occurred prin cip a lly in retailing and were largely the result o f a build-up o f auto inventories p rio r to the w ork stoppage in the autom obile industry and the sluggishness o f con sumer spending (see Chart 4). Inventory invest ment in m anufacturing and wholesale showed little change th ro u g h o u t the contraction. Subsequent to the trough in overall economic a c tiv ity in the fo u rth quarter o f 1971, however, it appears th a t the behavior o f wholesale and, p a rticu la rly, manu facturing inventory investment has been largely responsible fo r holding down the increase in total in v e n to ry investment. 5 0 [SEASONALLY ADJUSTED ANNUAL RATE—QUARTERLY The recent weakness in inventory investment in the m anufacturing sector has been largely in the d u ra b le goods industries, m ainly reflecting 3Q 4Q IQ 2Q 3Q 4Q IQ 2Q PEAK TROUGH 1969 197 0 1971 Lost entry: 2Q 1971 Source: U. S. Department of Commerce reductions in stocks at the "w o rk in process” stage of fa brication. In terms of specific industry groups, sizable reductions in inventory investment in recent months have occurred in electrical and nonelectrical machinery, blast furnaces and steel machinery through mills, and—during the firs t quarter o f 1971—in undoubtedly m o tor vehicles and parts. However, the reduction weakening trend o f capital spending th a t began in in inventory investment in m o to r vehicles and late 1969. In steel, the sharp decline in inventory 1970 and so far in reflects, to a large extent, 1971 the parts in the firs t quarter o f 1971 was, to some investment reflects the reduction in stocks th a t extent, a reflection o f the end o f the post-strike began last spring. These reductions were largely adjustment. The somewhat disappointing rebound the results o f increased steel shipments to auto in post-strike domestic auto sales and the resulting makers to buildup of some stockpiling th a t was prom pted by announcements cutbacks in schedules. The almost o f fu tu re price increases, and the prospect o f a dealer continuous decline 24 inventories production in inventory caused investment in support post-strike auto p ro d u ctio n , steel strike at the end o f July. N O V E M B E R -D E C E M B E R 1971 Chart 5. DEFENSE INVENTORIES AND DEFENSE INVENTORIES-SHIPMENTS RATIO B illio n s of d o lla r s I/ S Ratio * In August 1958, the Commerce Deportment began publishing a "new series" for defense products. The "new series" differs from the "old series" in that it includes defense activity in shipbuilding and excludes nondefense work in ordnance, communications, complete aircraft, and aircraft parts industries. Therefore, the "new series" more accurately represents the levels of defense activity. trends. The "old series" is used here to illustrate developments prior to 1968. However, both series reflect the same general For a more complete description of both the old and the new series, see, U. S. Department of Commerce, Bureau of the Census, "M anufacturers' Shipments, Inventories and Orders," Current Industrial Reports, Series M3-1 (68)-8 , October 12, 1968, p. 2 and footnote in Table 3. Last entry: Source: 2Q 1971 U. S. Department of Commerce DEFENSE INVEN TO R IES A fa c to r—other than sales, w o rk spending. A lthough defense stocks represent o n ly current and expected s to p p a g e s , and in fla tio n a ry a small p o rtio n o f to ta l business inventories, they have co ntributed to the recent weaknesses in expectations—th a t has had an im p o rta n t influence inventory investment. For example, the decline in on the behavior o f inventories in recent years is inventory defense activity. The level o f defense stocks more industries was larger than the decline in total than doubled during the 1965-1968 period (see inventory Chart 1970 and amounted to more than $2 b illio n in 5). However, defense inventories were reduced by nearly 15 percent between the th ird quarter of 1969 and the second investment in the defense products investment in the fo u rth quarter o f the second quarter o f 1971. quarter o f 1971, in response to a generally declining trend in SUMMARY AND IM PLICATIO NS new orders fo r defense products and commercial The moderate nature o f the 1969-1970 con aircraft and a substantial reduction in defense traction and the rather slow pace o f the recovery 25 ECONOMIC REVIEW so far this year were, in large part, the result o f contract expirations—w hich m ight result in sig n ifi small adjustments in business inventories. During cant hedging o f inventories—are pending in the the most recent contraction, the buildup in retail near term , other developments p o in t tow ard at stocks supported inventory investment and, there least a moderate increase in inventory investment fore, cushioned the decline in overall economic in the months ahead. In particular, there is some a ctivity u n til the fo u rth quarter o f 1970. However, evidence th a t the sharp decline in defense spending the lack o f any significant liq u id a tio n in total is bo tto m in g o u t; therefore, the decline in defense inventories during the contraction has lessened the inventories can reasonably be expected to taper need to rebuild stocks during the recovery. There o ff in the near fu tu re . However, the strength o f fore, the current expansion has n o t been bolstered inventory investment in the m onths ahead w ill by inventory investment to the same extent as in depend p rim a rily on the pace o f the expansion in previous recoveries. In fact, inventory investment overall declined more than $4 b illio n in the th ird quarter business sales and new orders fo r capital goods. of 1971, reflecting a c tiv ity and the grow th of a sharp reduction in steel stocks. A lthough the liq u id a tio n o f strike-hedged steel stocks is not ye t com plete11 and no major labor 26 economic 11.. It is estimated that in August, steel users cut 4 million tons of steel from the 12 1/2 million tons they were reported to have stockpiled as a strike hedge. Survey o f C urrent Business, September 1971, p. 2. ANNUAL INDEX TO ECONOMIC R E V IE W -1 9 7 1 MONTH A R TIC LE T IT L E JA N U A R Y D iffusion Indexes and Economic A c tiv ity Federal Laws Regulating Bank Mergers and the A cquisition o f Banks by Registered Bank H olding Companies FEB R UA RY Bank Credit Proxy Changes in Banks, Branches, and Banking Offices in the F ourth D istrict, 1965-1970 MARCH* Experience W ith Special Drawing Rights D irect Foreign Investment o f the United States A P R IL * Average Functional Cost and Revenue fo r Banks in Three Size Categories, 1966-1969 MAY* Eurobonds and the Eurobond M arket The 1972 Federal Budget and Economic A c tiv ity JUNE* Capital Spending in M ajor M etropolitan Areas o f the F ourth D istrict Consumer Income, Spending, and Saving, 1960-1970 JULY Some Characteristics o f Fourth D is tric t FCA Banks: A Comparison W ith the Other Member Banks The Secondary Mortgage M arket AUGUST U. S. Government Bonds As Capital M arket Instruments Characteristics o f Banks Acquired by M u ltip le Bank Holding Companies in Ohio SEPTEMBER OCTOBER Interpreting Short-run Price Developments D efining Money: Problems and Issues The Travel and Transportation Components o f the United States Balance o f Payments NOVEM BERDECEMBER Performance o f Rural Banks and Changes in Bank Structure in Ohio Inventory Investment and Economic A c tiv ity * O ut o f prin t.
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