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Federal Reserve Bank of Cleveland_____________
Economic Review




ISSN 0013-0281

Winter 1981-82

Economic Review is published quarterly by the Research D epartm ent of the Federal
Reserve Bank of Cleveland, P.O. Box 6387, Cleveland, Ohio 44101. Telephone: (216)
579-2000. Editor: Pat Wren. Graphics: Mike Whipkey. Typesetting: Sally Chunat.
Opinions stated in the 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.
M aterial may be reprinted provided th at the source is credited. Please send copies of
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W in te r 1 9 8 1 - 8 2
F e d e r a l R e s e r v e B a n k o f C lev ela n d
E c o n o m ic R e v ie w
C o n te n ts
A B asic A nalysis of the N ew P r o te c tio n ism ...........................2
Nations engaged in free international trade experience a long-term
rise in their real incomes, but often at the expense of temporary
resource-adjustment and income-redistribution problems. During
the 1970s the temporary adjustment problems associated with trade
seemed particularly acute, and protectionist sentiments increased
worldwide. Gerald H. Anderson and Owen F. Humpage illustrate
the costs associated with trade restraint, focusing on devices
currently used or recently proposed in the United States.
Operational Policies of Multibank Holding Com panies . . . 2 0
Motivated by a belief that multibank holding company (MBHC)
organizational structure and subsidiary bank performance would be
systematically related, several researchers investigated the
centralization policies of MBHCs over the past decade. In general,
these previous studies revealed that MBHC structural centraliza­
tion varied widely by policy area, both within and between com­
panies. However, these studies were completed, for the most part,
prior to the period of rapid MBHC expansion and maturation in the
1970s. Further, the samples used to generate the conclusions of
these studies generally were small and unrepresentative. For these
and other reasons, author Gary Whalen presents and discusses
recent data concerning MBHC operational policies. These data are
derived from a 1979 survey of the organizational structure of a
sample of 65 holding companies in 12 states.
Working Paper Review:
Multibank Holding Company Organizational Structure
and P erfo rm a n ce.....................................................................32
In a working paper summarized here, Gary Whalen explores
whether differences in MBHC organizational centralization are sys­
tematically related to differences in consolidated holding company
performance. The sample is cross-sectional, comprising 62 MBHCs
whose management responded to a survey of operational policies in
November 1979.




A Basic Analysis
of the N ew Protectionism
by Gerald H. Anderson and Owen F. Humpage

Since the early 1950s international trade has
become an increasingly important component of
the U.S. and world economies. In the 1970s the
adjustment problems caused by increased world­
wide competition seemed particularly severe
and heightened pressures both in the United
States and abroad for protection against imports.
The U.S. automobile and steel industries, for
example, have advocated trade policies to reduce
foreign competition in their industries. While
the United States and other countries generally
have balked at imposing tariffs and quotas, they
have instituted an array of seemingly less bla­
tant trade policies often referred to as the new
protectionism. These measures include both re­
straints on imports and incentives for exports,
and in some cases the costs of these programs
are greater than those of tariffs or quotas.
This article describes the costs that nations
incur by disrupting the free flow of international
trade, focusing on the new-protectionist policies
that are being substituted for the more conven­
tional interferences with trade, i.e., tariffs and
domestically administered quotas. Such devices
as gentlemen’s agreements, buy-American poli-

cies, quality standards, subsidies, anti-dumping
and countervailing duties, and restrictions on
direct investment are described in detail. All of
the techniques surveyed are currently used or
have considerable support in the United States.
It is not our intent to emphasize the differences
among the trade restraints and incentives con­
sidered here, but rather to show the similarities
among these trade policies. Both trade restraints
and incentives transfer income among groups of
individuals and impose net costs on the coun­
tries involved. Neither is preferable to free
international trade.
I. Free Trade and the
Effects of Trade Barriers
Since publication of Adam Sm ith’s Wealth of
Nations in 1776, economists have recognized the
benefits of free international trade. When one
nation specializes in goods that it can produce
relatively inexpensively and exchanges these
goods for items that another nation produces
relatively inexpensively, both nations benefit.
The benefits are manifested in lower prices and
a wider set of items available for consumption.
Consequently, real income is higher with trade
than without trade. The benefits of free inter­
national trade derive initially from differences
in comparative costs of production. Specializa­

Gerald H. Anderson is an economic advisor and Owen
F. Humpage is an economist, both with the Federal Reserve
Bank of Cleveland.



2

Federal Reserve Bank of Cleveland
tion and trade augment these benefits by in­
creasing the degree of worldwide competition,
encouraging international diffusion of new tech­
nology, and promoting economies of scale in
production. The greater the difference between
trading partners’ pre-trade price patterns, the
greater the gains from free trade.
If an economy is to reap the benefits of free
international trade, it also must incur the
resource-adjustment costs and income-redistribution problems associated with specialization
and trade. Trade changes relative prices and
forces a reallocation of resources. Over time, a
nation engaged in trade experiences further
changes in relative costs, technology, and tastes
that alter the composition of its exports, im­
ports, and domestic production. The adjustment
does not occur instantaneously, and during the
transition some resources—including people—
may be unemployed. After the transition, the
benefits of specialization and trade are not dis­
tributed evenly throughout the economy. Trade
theory suggests that the factor used intensively
in the production of a nation’s import commod­
ity may experience a decrease in its relative
wage as international trade expands. Conse­
quently, while total real income rises for a
nation expanding its trade, some groups within
a nation may suffer a reduction in real income.
Nations often impose trade barriers in an at­
tempt to reap the benefits of trade without in­
curring the associated transition costs and
income-redistribution problems. Trade barriers
are costly non-solutions, often involving effects
not anticipated by their proponents. They arbi­
trarily transfer income from consumers to do­
mestic producers, governments, and sometimes
foreign exporters and introduce net losses to
society resulting from production and consump­
tion inefficiencies.
The income-redistribution effects and net costs
of tariffs and quotas, classical protectionist de­
vices, are shown in figure 1. With the imposition
of a per-unit tariff (/), the price of the imported
good rises by the amount of the tariff (t = P i - Po).
Consumers, who purchase less at the higher
price, suffer a loss in purchasing power shown
in panel B by the lightly shaded area Po P i f h.



3

Not all of this income loss, however, is a net loss
to the home country. Part (area Po Pi e b) is
transferred to producers of the protected com­
modity through the higher prices they charge,
and part (area e f g h ) accrues to the domestic
government as tariff revenues. In addition to
these income transfers, the home country suf­
fers tariff-induced net losses stemming from
greater inefficiency in production and foregone
consumption opportunities. These net losses are
shown by the darkly shaded areas b e g and
d f h, respectively, in figure 1.
Quotas have effects similar to tariffs, with one
important difference involving area e f g h. In
the case of a tariff, the domestic government
captures this income in the form of tariff reve­
nues. In the case of a quota, the amount captured
by the home country depends on how import
licenses are sold. If import-license fees are set at
Pi minus Po dollars per unit, the home country
captures the entire area e f g h . On the other
hand, if import-license fees are set at less than Pi
minus Po per unit, part of the income lost by
consumers will accrue to foreign producers and
exporters rather than to the home country’s
government. Throughout this article it is as­
sumed that governments always capture these
revenues through the sale of import licenses
when imposing a quota.
Sometimes the consumer of a protected good
also is a producer, using the protected item as an
input to his own manufacturing process. A tariff
or quota on an input raises the cost of producing
with that input. A tariff on imported steel, for
example, increases the cost of producing domes­
tic cars and consequently may force domestic
car producers to seek protection against foreign
car imports. In this way protectionist measures
become catalysts of further trade restraint, espe­
cially along lines of production.
II. The N ew Protectionism
Realizing that the world is better off when
trade flourishes, developed countries have made
great advances toward lowering tariffs and lim­
iting quotas since World War II. Most of the
gains were made under the auspices of the Gen-

4

Economic Review □ Winter 1981-82

Fig. 1 Free Trade, Tariffs, and Quotas
Panel A Effects of Free Trade

Panel B Effects of Tariff or Quota

P rice

P rice

Sw

Im p o rts

Q u a n tity

Free Trade. A simple model of the market
for a single traded good is shown in panel A,
where line Dd represents the domestic (or home
country’s) demand schedule for a traded good,
and line Sd represents its supply curve. In the
absence of international trade, the home coun­
try would produce and consume 5 units of the
good in question at a price of P2 . The horizontal
line Swrepresents the world-supply schedule. A
horizontal world-supply curve results from the
assumption that the home country’s demand
for, and the supply of, the traded good is too
small relative to world supply to influence the
world price (Po). Under free international trade
the home country would consume 9 units of the
traded good at the world price of Po. Domestic



Im p o rts

Q u a n tity

producers would supply 1 unit of the good at
price P o, and imports would equal 8 units.
The benefits of trade accruing to the home
country relate to greater efficiency in produc­
tion and improved opportunity for consump­
tion. Consumers, for example, are willing to
pay the prices given along their demand curve
(Dd) for various quantities of the good; with free
trade, however, they pay only Po per unit. The
price difference for each additional unit pur­
chased represents a net gain to consumers. The
triangular area under the demand curve,
bounded by a' c' d \ equals the total tradeinduced net gain to the home country resulting
from the improved opportunity for consump­
tion. Similarly, domestic producers are willing

Federal Reserve Bank of Cleveland

to supply quantities of the good at prices given
by the supply curve (S«0, but a foreign producer
can supply the good at a lower price (Po). The
price difference for each unit represents a net
gain to the home country from improved effi­
ciency. The triangular area under the supply
curve bounded by a' b' c' equals the total tradeinduced net gain to the home country asso­
ciated with increased efficiency in production.
The total area a' b'd', therefore, represents the
net gains accruing to the home country from
free international trade.
In contrast, the area Po P2 a 'b ' does not
represent a trade-induced net gain or loss to the
home country. This area represents a realloca­
tion of revenues from domestic producers of
the traded good to consumers, resulting from
the lower price of the traded good. Consumers
use this revenue to finance additional pur­
chases of the traded good, as well as purchases
of other items. The amount spent on additional
imports eventually finds its way back to the
home country through exports or foreign direct
investments. Consequently, resources left un­
employed as a result of trade in time find
employment in other industries, although
probably only at lower relative wages (see, for
example, Luttrell 1981).
Tariffs and Quotas. If the home-country
imposes a per-unit tariff of P i minus Po on the
traded-good imports, the domestic price would
rise to Pi and domestic consumption would fall
to 7 units, as shown in panel B. The quantity
supplied domestically would rise to 3 units, and
imports would fall to 4 units. Consumers now
buy less and pay more, but part of their realincome loss is transferred to other sectors of
the domestic economy and does not represent a
net loss to the home country. The lightly
shaded area Po Pi f h represents the total de­
cline in consumers’ purchasing power. Part of
this real-income loss, given by the area
Po P i b e, accrues to domestic producers, who
now charge P i . This price exceeds the marginal
cost of production, given by the domesticsupply schedule, for each unit up to the third
unit of the traded good produced. Another por­



tion of the consumer-income loss, given by area
e f g h , goes to the domestic government as
tariff revenues. Like other tax receipts, tariff
revenues may be used to benefit consumers.
Tariffs, nevertheless, impose net losses on
the home country (and the world) from in­
creased inefficiencies in production and fore­
gone consumption opportunities. The part of
the net loss attributable to resources wasted by
shifting production to the less efficient domes­
tic producers is given by the darkly shaded
triangular area beg. Foreign producers can
produce the second and third units of the
traded good for less than domestic producers.
The part of the net loss attributable to foregone
consumption opportunities is given by the
darkly shaded triangular area d f h . Under the
free-trade price of Po per unit, consumers
would have purchased an eighth and ninth
unit of the traded good. Notice, too, that the
more price-elastic the home country’s demand
and supply, the greater the net losses asso­
ciated with the tariff.
Imposing a quota instead of a tariff alters the
conclusions in one important respect. Assume
that the government imposes a quota, limiting
imports to only 4 units. Again, the free-trade
situation depicted in panel A is altered to that
shown in panel B, as the domestic market bids
up the price of the traded good to P i. The
decline in consumers’ purchasing power again
is given by area Po P i f h , and triangles b e g
and d f h indicate the net losses to the world.
The major difference between the tariff and
quota involve the area e f g h. In the case of a
tariff, this amount accrues to the domestic
government as tariff revenues. In the case of a
quota, the share of area e f g h obtained by the
home country depends on how import licenses
are issued. If, for example, the home country
sells import licenses at a price of P i minus Po
dollars per unit, it would capture the entire
area e f g h. Alternatively, if import licenses
are sold at a lower price or are given to foreign
governments, producers, or exporters, those
groups would receive part or all of the income
lost by consumers.

5

6

Economic Review □ Winter 1981-82

eral Agreement on Tariffs and Trade (GATT),
initially negotiated in 1947 (see box). This period
of increasing trade liberalization lasted until the
early 1970s, when the Organization of Petro­
leum Exporting Countries’ price increases and
the harsh worldwide recession of 1974-75 created
balance-of-payments and employment problems
more severe than the typical cyclical patterns.
The ensuing climate of slow real growth, high
unemployment, and reduced productivity gains
created a more difficult environment in which
trade-induced resource adjustments could be
made. Since the early 1970s, there has been a
noticeable increase in pressures for trade
protection, as Balassa (1978) and Tumlir (1979)
have observed.1
Recent protectionist measures, however, have
distinguished themselves from those of previous
periods, consequently earning the label new pro­
tectionism. The most obvious distinguishing
characteristic of the new protectionism is its re­
jection of the tariff and, to a lesser extent, the
quota. A GATT inventory completed in 1981
lists more than 600 separate non-tariff barriers
that affect industrial-products trade.2 In part,
the growing importance of non-tariff trade bar­
riers can be attributed to the success of GATT.
The first six GATT negotiations dealt almost ex­
clusively with tariff reductions; it was not until
the Tokyo Round, concluded in 1979, that GATT
began considering non-tariff barriers. The growth
of the new protectionism may reflect an attempt
by countries to institute trade restraints without
destroying GATT as a multinational forum for
discussing trade problems. Even with the Tokyo
Round, there is ample room for countries to im­
pose trade barriers. Nevertheless, the prolifer­
ation of non-tariff barriers is attributable to
more than just the relative demise of tariffs and
the desire to maintain GATT.
1. K rauss (1978) argues th a t increased protectionism is a
natural extension of the growing role of governm ent in the
economy.
2. GA T T Focus, February 1982, p. 2. GATT is preparing a
corresponding inventory for agricultural products. See also
Inventory of Industrial N T B s, U.S. D epartm ent of Com­
merce, W ashington, D.C., 1973.



Under floating-exchange rates, non-tariff trade
barriers have the added advantage of providing a
more constant degree of restraint than ad valorem
tariffs, which are imposed at a fixed percentage of
the value of the goods. An exchange-rate change
that lowers the home currency price of imports,
for example, proportionately reduces tariff duties
and the degree of protection the tariff affords.
Quantity restraints are insensitive to such ex­
change-rate movements and consequently have
become relatively more attractive than tariffs.
Another major reason for the relative growth of
the “nontraditional” forms of protectionism is
that they are, in some cases, more palatable to for­
eign producers and their governments than ta r­
iffs or quotas administered by the home country.
Trade-policy negotiations often involve a quid pro
quo\ many new-protectionist measures enable for­
eigners to capture part or all of the economic
rents created by trade restraints. As explained
in the discussion of gentlemen’s agreements, the
quid pro quo often can be directed more closely to
affected parties.
Another reason for the proliferation of the new
protectionism is that the techniques often are not
blatantly anti-trade. Krauss (1978) argues that al­
most anything governments do to intervene in the
private sector has consequences for international
trade. Loan guarantees, such as those extended to
Chrysler Corporation, are designed as domestic
employment policies; nevertheless, they increase
a firm ’s ability to compete against foreign pro­
ducers. New-protectionist techniques, such as
quality standards, often do not appear as overtly
anti-trade as tariffs or quotas, but their effects
often are similar.
In fact, many of the new-protectionist devices
inflict greater net losses on the home country
than tariffs or quotas, because they allow for­
eigners to acquire the economic rents that the
home country would capture as tariff revenue or
import-license fees. Moreover, many of the newprotectionist measures function as quotas, re­
stricting the market mechanism more severely
than a tariff. Although tariffs distort market out­
comes, they nevertheless allow shifts in demand
(e.g., through changing tastes) and supply (e.g.,
through efficiency gains) to influence the quan-

Federal Reserve Bank of Cleveland

7

General A greem ent on Tariffs and Trade
The General Agreement on Tariffs and Trade
(GATT) is a multilateral treaty for reducing
existing trade barriers and defining rules for
conducting international trade. The agree­
ment also provides a forum for discussing
international trade disputes. The principles
underlying GATT are widely accepted; rough­
ly four-fifths of world trade currently is con­
ducted by nations supporting the agreement.
GATT grew out of efforts by the United
States during World War II to seek multi­
national tariff reductions. Concluded in 1947,
the first negotiating session, or round, led to
the GATT framework as well as significant
tariff reductions. Twenty-seven nations par­
ticipated at that time. In the sixth or Kennedy
Round, which was concluded in 1967,53 partic­
ipants reduced industrial tariffs by two-fifths on
average. The seventh or Tokyo Round was
concluded in 1979 and marked an important
advance in GATT negotiations. For the first
time participants specifically addressed non­
tariff trade barriers.
The most important principle underlying
GATT is that nations should be nondiscriminatory in conducting trade. Embodied in the
“most-favored-nation” clause (Art. I), this
principle holds that trade privileges offered to
one country should be extended immediately
and unconditionally to all nations. The non­
discrimination principle is primarily respon­
tity of imports. In this sense a tariff does
not totally eliminate the market mechanism.
Quotas, as Balassa (1978) observes, do not allow
shifts in supply and demand to increase the
amount imported.

Gentlemen's Agreements
An increasingly common form of new protec­
tionism that is particularly favored in the United
States is the gentlemen ’s agreement, whereby an
exporting country “voluntarily” restricts ship­
ments of specific commodities to an importing
country. A gentlemen’s agreement essentially is



sible for the success of GATT in reducing trade
barriers and encouraging international trade.
A second important principle holds that trade
barriers that are necessary should be in the
form of tariffs. Quotas are largely prohibited.
Tariffs discourage competition and efficiency
somewhat less than quantitative restrictions.
A third principle deals with consultation and
negotiation: countries should meet under GATT
auspices to discuss trade problems, and re­
straints should be negotiated.
Despite GATT, trade restraints do exist.
Some restrictive trade practices in existence
before GATT were continued under a grand­
father clause, thought necessary for the agree­
ment’s successful negotiation. Customs unions
and free-trade areas can discriminate against
nonmembers. Participants apparently believe
that the trade-creating effects of these organi­
zations exceed the trade-distorting effects.
Quantitative restrictions are permissible in
cases of balance-of-payments difficulties, and
“safeguard” provisions allow nations to insti­
tute import restrictions on goods that threaten
serious injury to domestic producers. Moreover,
“voluntary” restraints generally are viewed as
consistent with GATT. Import restraints also
reflect, to a limited extent, the fact that GATT
is not international law. It is a contract ulti­
mately enforced only by national honor, inter­
national prestige, and the threat of retaliation.
a quota, but one that allows the foreign ex­
porting country to capture much of the economic
rents associated with trade restraint. Conse­
quently, the costs associated with gentlemen’s
agreements typically exceed the costs of an
equally restrictive tariff or quota.
The rising use of gentlemen’s agreements
partially reflects the relative ease with which
they can be enacted and the flexibility with
which they can be administered. Whereas quotas
result from specific legislation and are subject to
congressional review, gentlemen’s agreements
usually are established by a specific admini­
stration under its ability to conduct for­

8

Economic Review □ Winter 1981-82

eign policy.3Bergsten (1975) suggests that being
adm inistrative in origin leaves gentlemen’s
agreements open to abuse; others argue that
many secret gentlemen’s agreements have re­
sulted from their not being subject to legislative
review (see Morkre and T arr 1980, p. 36). Gen­
tlemen’s agreements usually are negotiated bi­
laterally for specific commodities, whereas quo­
tas are determined unilaterally for protected
commodities from all nations. In 1981, for ex­
ample, the Reagan administration negotiated a
gentlemen’s agreement with Japan to restrict
automobile imports, but did not seek similar re­
straints against German, British, French, or
Italian car imports. Because of the bilateral
aspect of a gentlemen’s agreement, the foreign
exporting country has more influence on the
agreement terms than under a quota. Often, for
example, gentlemen’s agreements allow exporters
to borrow in any given year against future
limitations or against past, unused limitations.
Because gentlemen’s agreements are discrim­
inatory, they violate the spirit of GATT’s mostfavored-nation clause. Nevertheless, negotiations
currently are under way to sanction the use of
gentlemen’s agreements under GATT’s “safe­
guard” provisions. Proponents of this protec­
tionist device argue that, because gentlemen’s
agreements are voluntary, they conform with
the GATT philosophy. Exporting countries, how­
ever, frequently must negotiate gentlemen’s
agreements under threat of tariffs or quotas that
is less desirable from their perspective. Export­
ing countries usually do not view gentlemen’s
agreements as voluntary.
Bergsten (1975) suggests that gentlemen’s
agreements may be less restrictive than tariffs
or quotas, in part because the exporting country
organizes the market and because the incentives
to ensure strict compliance are smaller for the
3. Strictly speaking, there are two types of gentlem en’s
agreem ents: orderly m arketing agreem ents (OMAs) and
voluntary export restrain ts (VERs). OMAs are formalized
VERs, authorized under the 1974 T rade Act, subject to spe­
cific procedural stages (petition, hearing, review) and some­
tim es to congressional reversal. VERs are established under
adm inistrative powers and are not subject to congressional
or public scrutiny. See Morkre and T a rr (1980), pp. 35-7.



exporting country than for the importing coun­
try. The enforcement efforts of a foreign govern­
ment strain its ties with its own business com­
munity and often require the development of a
costly bureaucracy to administer the program.
More importantly, however, gentlemen’s agree­
ments may be less restrictive than tariffs or
quotas, as they do not affect all foreign ex­
porters. Actually, gentlemen’s agreements may
stimulate exports from non-restrained foreign
producers. In 1977, the Carter administration
entered into a gentlemen’s agreement with Japan
to restrict U.S. imports of Japanese color tele­
visions. Morkre and T arr (1980) argue that the
restrictions on Japanese televisions contributed
to such a large increase in color-television im­
ports from South Korea, Taiwan, Mexico, Singa­
pore, and Canada that the total volume of such
imports into the United States in 1978 exceeded
that of 1977. Restrained exporters sometimes
invest in other foreign countries to circumvent
protectionist measures; or they sometimes ship
goods produced in restrained countries through
non-restrained nations to disguise their origin.
The substitution phenomenon often results in
pressures to negotiate additional gentlemen’s
agreements with other producing countries.
Bergsten (1975) argues that these non-restrained
countries, fearing future gentlemen’s agree­
ments, may encourage exportation of commodi­
ties to build a larger export base against which
to negotiate. Similarly, restrained countries con­
tinuously may strive to meet their quotas to
prevent future cuts if existing gentlemen’s agree­
ments are renegotiated.
Nations bent on trade restraint theoretically
can negotiate and police a network of gentle­
men’s agreements as restrictive as any quota. In
such cases the importing country might incur
costs greater than those of an equally restrictive
quota. In the case of a quota administered so that
the importing country’s government captures
all of the export-license fees, the net cost to
society associated with restraint is shown in
figure 1, panel B, to equal the darkly shaded
areas b e ^and d f h . In the case of a gentlemen’s
agreement, however, the home country incurs
an additional net cost equal to the foregone

Federal Reserve Bank of Cleveland
import-license fees shown by the lightly shaded
area e f g h. These foregone revenues accrue to
foreign exporters in the form of economic rents
associated with the price increase or to the
foreign governments that enter into a gentlemen’s
agreement as export-license fees.
Although the economic costs of gentlemen’s
agreements exceed those of equally restrictive
quotas, they offer certain advantages for inter­
national diplomacy not found in the more tradi­
tional protectionist measures. A nation institut­
ing protectionist measures often provides some
form of quid pro quo to reduce the likelihood of
foreign retaliation. This may take the form of
eliminating tariffs or quotas on one commodity
while imposing them on another. In the case of
gentlemen’s agreements, however, the quid pro
quo is automatic, taking the form of the eco­
nomic rents transferred to foreigners. Through
its issuing of export licenses, the exporting
government often can direct these rents to the
firms most severely affected by the gentlemen’s
agreement and simultaneously may gain greater
political influence over the industries affected
by the gentlemen’s agreement. Small foreign
firms unaffected by the restraints naturally find
gentlemen’s agreements attractive, but large
firms also may find them attractive if the issu­
ance of export licenses stabilizes competition.
The middle-sized foreign firms, growing rapidly
in the export market, would be the most severely
harmed by gentlemen’s agreements.

Buy-American Policies
The United States, like many other countries,
has a history of procurement policies that dis­
criminate against foreign suppliers. Govern­
ments usually adopt such policies to promote
self-sufficiency, particularly in the production
of military goods or high-technology items, or to
offer implicit subsidies to specific producers.
The U.S. government, in sharp contrast to most
of its foreign counterparts whose discrimination
is less open, has stated explicitly its preference
for domestic producers and has followed a policy
of price favoritism. A domestic price must exceed
a foreign price by a specific margin before pro­



9

curement officers may buy the foreign item.
Until recently, domestic producers were allowed
a margin of 6 percent over foreign prices in
most circumstances, 12 percent in the case of
small businesses, and 50 percent for de­
fense procurement.4
Many governments follow a more subtle form
of discriminatory procurement, called general
favoritism. As the name implies, general favor­
itism takes forms that often are not blatantly
discriminatory. A frequent device is the use of
selective-tender, or single-tender, bids rather
than public-tender bids for government con­
tracts. Bidding often is announced with little
notice or information so that foreigners, un­
familiar with government-procurement policies,
are unable to compete. When high-technology
items are involved, governments may develop
the procurement specifications in consultation
with local firms, limiting the ability of foreigners
to compete. There are a myriad of similar ex­
amples of general favoritism.
Buy-American policies, like all protectionist
measures, result in transfers from consumers
via taxes to producers and net losses to society
as a whole. Figure 2 illustrates this for the case
when r represents the margin established under
price favoritism, Po is the foreign-supply price,
and P% equals the domestic, pre-trade supply
price. Because P2 is less than P0 (1 + r), no for­
eign goods are purchased by the home govern­
ment. The shaded area P0P2 a c represents the
total cost of the home country’s policy. Of this
amount, the lightly shaded area P0 P2 a b is an
income transfer to domestic producers, and the
darkly shaded area a b c represents a net cost
to society associated w ith inefficiencies
in production.5
4. D iscrim inatory governm ent-procurem ent policies were
discussed at the Toyko Round of GATT. The participants
established a detailed set of rules governing procurement
policies, w hich the United States adopted beginning in 1979.
As w ith most GATT rules, however, many exemptions
exist, particularly in the high-technology and defense sectors.
5. The results would be sim ilar under general favoritism,
but r would then represent the per-unit dollar value of the
restrain t. Also, figure 2 assum es governm ent demand is
perfectly price inelastic; consequently, favoritism results in
no losses associated w ith consum ption changes.

10

Economic Review □ Winter 1981-82

Fig. 2 Effects of Buy-American
Policies
Price

Q u a n tity

Richardson (1972), however, argues that the
effectiveness of buy-American policies in pro­
viding subsidies to domestic producers and in
curbing imports depends on the overall ability to
substitute foreign and domestic goods and the
degree of competition in the domestic market. If,
for example, domestic and foreign goods are pro­
duced in perfectly competitive markets and are
perfect substitutes in consumption, no subsidy
or import restraint would result from a buyAmerican policy. The shift in government
demand away from foreign-produced goods
toward domestically produced goods places up­
ward pressure on the domestic price and down­
ward pressure on the foreign price, causing an
equal, but opposite, shift in private-sector de­
mand. The government would purchase more of
the domestically produced good, while the pri­
vate sector would purchase more of the foreignproduced good. The total levels of domestic pro­
duction and imports, however, remain unal­
tered, and the domestic price would not rise
above the world-market price; no subsidy to
domestic producers would result.



Quality Standards
Governments often impose quality standards
on goods and services within their jurisdictions.
These include health and safety standards,
consumer-protection requirements, and environ­
mental regulations. Governments usually estab­
lish such standards to improve the efficient
functioning of markets. Ideally, quality stan­
dards compensate for consumers’ lack of perfect
information about products and their effects.
Often, however, quality standards create market
inefficiency, particularly when they discrimi­
nate against imported goods by intent or design.
There are several ways in which quality
standards can discriminate against imports.
The most obvious case, of course, is when qual­
ity standards apply only to imported goods or are
more rigorous for imported goods than for do­
mestic goods. Less obvious, but more important,
is when quality standards specify design instead
of performance criteria. For example, electrical
devices usually require insulation, but there are
many different insulating materials that can be
used successfully. A design criterion that speci­
fies a particular material to be used in insulation
may discriminate against a comparable foreign
product that uses a different material but
achieves the same degree of insulation. As a
general rule, quality standards, written in terms
of performance rather than design criteria, have
a more neutral impact on imports. Even when
written in terms of performance criteria, quality
standards can discriminate against imports if
their interpretation and enforcement procedures
are not clearly explained to foreign producers.
This lack of information raises the risks and
perceived costs of trade. Just a delay for inspec­
tion of goods can be very costly, particularly
when it is not anticipated. Goods may set in
warehouses awaiting inspection, accumulating
storage charges and interest costs, while sea­
sonal goods may miss their peak selling season.
Discriminatory quality standards that reduce
imports and raise the prices of traded goods have
effects similar to tariffs and quotas. If, for
example, a quality standard raises the cost and
price of imported goods, the standard results in a

Federal Reserve Bank of Cleveland
transfer of income from consumers to domestic
producers and a net cost associated with con­
sumption and production inefficiency as shown
in figure 1, panel B. In this case the quality
standard has the same effect as a specific tariff.
If, however, the discriminatory quality standard
is so stringent that it precludes foreign competi­
tion in domestic markets, it serves as a prohibi­
tive tariff or zero quota.

Subsidies
Although not viewed as trade restraints, sub­
sidies affect income distribution and economic
efficiency in ways strikingly similar to tariffs
and quotas. Subsidies that affect international
trade are utilized for production of import sub­
stitutes, exportation of goods, and production of
export goods. Subsidies for the production of
import substitutes benefit local producers in
direct competition with importers. An export
subsidy applies only to units exported; a produc­
tion subsidy on an export good applies to units
sold in the domestic market as well.
Subsidies can take many forms. A cash bounty
paid to a producer is the most direct and obvious
subsidy, but many indirect subsidies are pos­
sible. Governments might provide services or
production facilities at less than market values
to producers and might excuse producers from
certain taxes. Governments also might subsi­
dize the production or the import of raw mate­
rials used by an industry. The Export-Import
Bank and Domestic International Sales Corpo­
rations are the primary means in the United
States to subsidize exports, but the federal
government also influences the international
competitiveness of U.S. firms indirectly through
programs such as loan guarantees.
Some subsidies, such as direct lump-sum pay­
ments, are easy to identify and measure, while
other subsidies may be harder to detect. If, for
example, a foreign government grants a lowinterest loan, the subsidy depends on the differ­
ence between the actual interest rate and the
market rate, but it may not be clear how much
the firm would pay for a comparable loan in the



11

free market. Similarly, if there is a subsidy to an
industry that supplies raw materials, such as
coal, to an exporting industry, such as steel, it
may be difficult to measure the benefit passed
through to the export industry. Foreign govern­
ments sometimes provide payments to firms to
offset burdens placed on them, such as excise
taxes or requirements that they continue opera­
tion of an inefficient plant to avoid unemployment.
The income distribution and efficiency impli­
cations of subsidies are illustrated by the models
developed throughout this article. Figure 3 illus­
trates the comparative statics of subsidizing the
production of an import substitute. The subsidy
effectively shifts the domestic-supply schedule,
(Sd), downward to S'd, and its per-unit cost is
equal to the vertical distance between the two
schedules (<5). The subsidy results in an income
transfer from all taxpayers to the owners and
employees of the subsidized firm. The demand
curve remains unaltered under the assumption
that all three groups are consumers of the good

Fig. 3 Effects of a Production Subsidy
for an Import Substitute
P rice

........— ■
Im p o rts

Q u a n tity

12

Economic Review □ Winter 1981-82

with like preferences. Domestic production ex­
pands by 1 unit, imports fall by 1 unit, and total
consumption is unchanged. The total amount of
the subsidy, which is borne by taxpayers, is
represented by area a c f e. Of this total, the
amount indicated by area b c f e is not a net cost
to the home nation but an income transfer to
domestic producers. Area a b c, however, repre­
sents a net cost associated with shifting to the
less efficient domestic producer, showing the
additional resources required for domestic pro­
duction compared with foreign production. These
resources are bid away from production of some
other good.
Because export subsidies increase trade, pro­
ponents view them as opposites of tariffs; how­
ever, export subsidies are similar to tariffs in
that both cause inefficiencies and income trans­
fers. Figure 4 illustrates the domestic market for
an export good. Without a subsidy, world and
domestic prices are both Pi. Domestic produc­

Fig. 4

Effects of an Export Subsidy

Price




tion is 7 units, of which 4 are consumed at home
and 3 are exported. When the government offers
a subsidy for exports equal to <5 per unit, pro­
ducers raise the domestic price to equal the sum
of the unchanged world price plus the subsidy.
The increase in revenue per unit sold induces
additional domestic production, which rises to 9
units. Domestic consumption falls to 3 units
because of the price increase, and exports rise to
6 units. This analysis assumes that (1) the
exporting nation is a relatively small supplier so
that its increase in exports does not change
world price, and (2) some barrier to imports en­
ables the new domestic price P2 to remain above
world price Pi.
The producers’ profits rise by PiP2 b e. Tax­
payers bear the cost of the subsidy a b c /, as­
suming a subsidy is paid for all units exported,
and domestic consumers pay P1 P2 a c more for
the 3 units that they purchase. Producer profits
rise by less than the sum of the subsidy and the
additional payments from consumers because of
the efficiency cost b e f associated with produc­
ing goods that foreign consumers value, at the
margin, less than the marginal cost of producing
them. In addition, there is a loss of consumer
surplus a c d caused by the reduction of do­
mestic consumption.
Implicit in the foregoing discussion is the
assumption that trade barriers or strong con­
sumer preferences prevent home-country con­
sumers from importing the traded good. In the
absence of such impediments to trade, the do­
mestic price would remain at the world price Pi,
and 4 units of the traded good would be imported.
Domestic producers would continue to produce 9
units; under the incentive of an export subsidy,
they would sell their entire stock abroad. The
total subsidy would equal P 1 P2 b f. Consequently,
an export subsidy may raise imports and ex­
ports, as producers transfer products to the
export market and consumers switch to im­
ported substitutes.
The case of a production subsidy for an export
good is illustrated in figure 5. Again, the analysis
assumes that the exporting nation is a relatively
small supplier so that it cannot influence the
world price, which also equals the domestic

Federal Reserve Bank of Cleveland

Fig. 5 Effects of a Production Subsidy
for an Export Good
P rice

price at Pi. Because the subsidy applies to all
units, whether sold at home or abroad, domestic
producers view it as a reduction in costs rather
than an increase in the world price. It can be
represented by shifting the supply curve Sa
down by <5, the per-unit subsidy, to Sa. Without
the subsidy, production is 7 units, of which 4 are
consumed at home and 3 are exported. With the
subsidy, production rises to 9 units, domestic
consumption is unchanged at 4 units, and ex­
ports rise to 5 units.
Again, taxpayers bear the cost of subsidy
a d e f. Producers’ profits rise by c d e f, less
than the subsidy. The difference reflects the net
cost (a c d) associated with transferring produc­
tion of the eighth and ninth units from more
efficient foreign producers to less efficient do­
mestic producers. There is no loss of consumer
surplus, however, because domestic price and
consumption are unchanged.



13

Although both an export subsidy and a pro­
duction subsidy increase production and ex­
ports, the export subsidy diverts resources more
directly to the export market than the produc­
tion subsidy. Export subsidies, therefore, are
more threatening to producers outside the sub­
sidizing country, which partially may explain
why GATT opposes export subsidies more
strongly than production subsidies.
The foregoing analysis assumes that in­
creases in exports caused by export and produc­
tion subsidies are too small to affect the world
price of the product. If such is not the case, then
the subsidies would lead to a decline in world
price, less benefit to domestic producers, and
greater loss to foreign producers. Foreign nations
would experience a net benefit, as foreign con­
sumers gain more than foreign producers lose.
This can be understood by observing that the
reduction in price of the export good transfers
wealth from the subsidizing, exporting country
to the importing country.
If the subsidy is permanent, the importing
country must be a beneficiary of the exporting
country’s generosity. A subsidy that is not per­
manent may be disadvantageous for both the
importing country and the exporting country. A
subsidy that is not known to be temporary in­
duces shifts of productive resources among
industries that later must be reversed when the
subsidy is removed. Thus, a temporary subsidy
is always costly for the exporting country and
may be costly for the importing country, depend­
ing on how long the subsidy remains in effect.

A nti-D um ping and Countervailing Duties
Anti-dumping and countervailing duties are
tariffs designed to protect domestic industry at
the expense of domestic consumers; they differ
from traditional tariffs in that they are imposed
only when foreign competition is deemed
“unfair.” The anti-dumping law imposes duties
on foreign goods sold in the United States at less
than “fair value” if such sale causes “material
injury” to a U.S. industry. Fair value is the
price charged in the exporter’s home country. If
the goods are not sold in the exporter’s country,

14

Economic Review □ Winter 1981-82

or are sold there at an unreasonably low price,
then a fair value is constructed as the sum of
materials and labor costs, general expenses, and
profit. General expenses are calculated arbitrar­
ily as 10 percent of materials and labor costs,
and profit is 8 percent of materials, labor, and
general expenses. Shipping, insurance, and U.S.
tariffs also are added to the fair value.
Occasionally, it is argued that anti-dumping
duties are necessary to prevent predatory pric­
ing, i.e., situations in which foreign suppliers
initially charge low prices until all competition
is eliminated and then charge monopoly prices.
To eliminate all competition (home-country and
worldwide), a foreign firm would require prodi­
gious financial strength.
Anti-dumping duties result in the income dis­
tribution effects and efficiency costs described
in figure 1. These duties involve administrative
costs greater than those associated with tariffs
because of the costs of determining fair value
and material injury.6 Anti-dumping duties are
discriminatory in many ways. They permit low
foreign prices that reflect, for example, low for­
eign wages, but do not allow low foreign prices
that result from profit margins under 8 percent.
A price may fall below the fair-value definition
for a product from one country, but not for the
same product from another country if it is pro­
duced there at lower cost. Anti-dumping duties
can deny U.S. consumers access to low-priced
goods merely because consumers in the export
country pay more for the same goods. The anti­
dumping law also fails to allow for exchangerate fluctuations. A rise in the value of the
exporter nation’s currency would increase the
fair-value dollar price of their exports, even if
the exchange-rate change is temporary. This
would imply that foreign exporters, following a
temporary exchange-rate change, would have to
6. Material injury is an im precise term . All im ports,
w hether sold at fair value or not, are injurious, to some
degree, to the domestic firm s against which they compete.
U.S. law does not define m aterial injury, except by saying it
m eans “harm w hich is not inconsequential, im m aterial, or
u nim portant.” Instead, the law directs the International
T rade Commission to determ ine w hether there is m aterial
injury in each case.



raise prices for their goods sold in this country
and risk the loss of markets that had been culti­
vated over time.
The countervailing-duty law is based on the
premise that it is unfair to U.S. firms to compete
with foreign firms that are subsidized by their
governments. If subsidized goods are deemed by
the International Trade Commission to be inj urious to a U.S. industry, countervailing duties can
be imposed to offset the subsidies. By discour­
aging subsidized imports, countervailing duties
reduce the ability of the United States to benefit
from the largess of our trade partners.
Anti-dumping and countervailing-duty com­
plaints are difficult paths for U.S. firms to fol­
low. An anti-dumping petition, for example,
must be specific to a product and firm, so dozens
of petitions may be necessary in an industry
such as steel, with its many foreign producers
and categories of products. To obtain relief,
injury as well as dumping must be proved. If
dumping occurs during a boom, it is hard to
demonstrate injury when output, sales, and
profits are rising. If dumping occurs during a
recession, it is hard to show that the problem is
dumping rather than slack domestic demand.
And if the recession ends before the case is com­
pletely adjudicated, there may be political pres­
sure to drop the complaint. Improved business
conditions would have reduced the injury, and
recent administrations generally have disliked
anti-dumping cases because of adverse reactions
of our trading partners.
The trigger price mechanism (TPM) is a
recent innovation for enforcing U.S. anti­
dumping and countervailing-duty laws. Imple­
mented in 1978 and suspended in January 1982,
the TPM established reference prices for steel.
Im ports below the reference price would
“trigger” an anti-dumping or countervailingduty investigation. Thus, the TPM was not a
new device for protection but an administrative
mechanism for providing better enforcement of
existing laws.7
7. The TPM is described fully in Gerald H. Anderson, “The
Steel Trigger Price M echanism ,” Economic Commentary,
Federal Reserve Bank of Cleveland, forthcoming.

Federal Reserve Bank of Cleveland

Barriers to Trade in Services
Services, an important component of interna­
tional trade, also are subject to protectionist
barriers. Shipping, banking, insurance, data
processing, construction, and consulting are
examples of services sold internationally. Ser­
vices, excluding investment income, accounted
for 14 percent of U.S. exports in 1980 and 1981.
Restrictions on service imports are wide­
spread. For example, some nations prevent for­
eign banks from establishing branches or subsid­
iaries, while others discourage the use of foreign
insurance companies. The United States ex­
cludes foreign ships from transporting goods
between U.S. ports. A catalogue of over 2,000
barriers to free trade in services has been com­
piled by the U.S. government.8
Barriers to trade in services impose the same
costs and distortions as barriers to trade in
goods. Often they are rationalized by concern
about national defense or independence. How­
ever, in many cases the true motivation is
defense of a domestic industry rather than
defense of the nation.
GATT does not address the issue of barriers to
trade in services. The Office of the United States
Trade Representative is working to obtain a
commitment from other nations to discuss the
matter, but it may be years before the start of
any negotiations to reduce these barriers.
Protectionism and Foreign Investment
The term protectionism usually refers to trade
in goods and services, but it also pertains to
international movements of capital, especially
direct foreign investment.9 Advocates of protec­
tionist measures directed at stemming capital
outflows and encouraging capital inflows often
base their arguments on the impacts that such
capital flows have on labor. It is alleged that
capital outflows (1) reduce labor’s share of real

8.

15

earnings relative to capital’s share by lowering
the domestic capital-to-labor ratio, (2) increase
domestic unemployment, and (3) reduce unionbargaining powers. Capital inflows have an
opposite effect.
Empirical results on these issues are mixed,
depending crucially on what is assumed to
happen in the absence of direct foreign invest­
m ent.10 Labor organizations, for example, have
argued that U.S. direct foreign investments
reduce domestic investment, employment, and
income, and they have sought to limit such
investment by raising taxes on foreign profits
(see Humpage 1980-81). Implicit in this argu­
ment is the view that U.S. firms can compete in
foreign markets equally as well through domes­
tic production and export as through direct for­
eign investment. This view of international
competition, however, is not always valid, par­
ticularly in the long run.
Exporting often proves to be the most profit­
able way for U.S. firms to conduct international
business, but in many cases direct foreign invest­
ment may be a more profitable, or the only prof­
itable, means to enter and grow in foreign
markets. Often trade barriers or high-transportation costs preclude exporting. Other times,
the nature of the product may dictate foreign
production rather than exporting. Consumergoods sales, for example, may be highly sensitive
to design and style and require a degree of tailor­
ing to local markets or brand identification not
afforded through exporting. Similarly, sophisti­
cated producers’ goods may require servicing,
frequent repair, or adjustments. Direct foreign
investment also may enable firms to predict
market changes more accurately and to secure
access to scarce or low-cost resources that cannot
be imported.
Exporting may be very profitable if a high
degree of product differentiation exists. Over
time, however, foreign firms may develop
competing products and grow rapidly because of
their proximity to the market. In such circum-

Wall Street Journal, October 5, 1981, p. 1.

9. Direct foreign investm ent generally refers to capital
flows through w hich investors attain a significant degree of
control over a foreign firm.



10. See Bergsten, Horst, and Moran (1978) and McCulloch
(1979) for brief surveys of the empirical work.

16

Economic Review □ Winter 1981-82

stances, local production may be the only method
through which a U.S. company can maintain a
share of the foreign market. In the absence of
foreign investment, U.S. firms may become less
profitable and the growing foreign firm may
seek a share of the U.S. market through exporting.
Stobaugh (1976) suggests that such circumstances
eventually may reduce domestic investment.
It is similarly unapparent that direct foreign
investment increases U.S. imports or decreases
U.S. exports (see Bergsten, Horst, and Moran
1978). Direct foreign investment, particularly
initial investments, often occurs in marketing
and warehouse facilities to promote the firm ’s
exports; often investment occurs in assembly
operations and encourages trade in parts. But,
even when investment occurs in vertically inte­
grated foreign plants, it may encourage the
export of capital goods for expansion and the
export of a multitude of complementary goods
and services. Furthermore, multinational firms
usually are more adept than their domestic
counterparts at finding new export markets.
Most important, however, even in cases where
U.S. firms invest abroad to import goods back
into the United States, the possibility exists that
if a U.S. firm did not exploit this opportunity, a
foreign firm would. Then restraint on invest­
ment would not reduce imports.
For the same reasons that domestic labor
organizations have sought to restrict U.S. invest­
ment abroad, they have sought to encourage for­
eign investment in the United States. Foreign
firms might be induced to produce in the United
States by establishing trade barriers and offer­
ing tax incentives. Many countries impose localcontent requirements that mandate some per­
centage of the value of a product that must be
added within the country where the goods are
sold. For example, automobiles assembled in
Mexico must have at least 50 percent of their
value added locally. U.S. labor organizations
have argued that firms selling in the United
States should have some production facilities
located here. While a shift from imports to
domestic production may increase employment
and labor bargaining power, the home country is
not necessarily better off.



A foreign firm whose exports capture a share
of a U.S. market, characterized by imperfect
competition but fairly homogeneous products,
must have a cost advantage over the domestic
firm s’. A cost advantage would be necessary to
offset the high risks associated with foreign
trade. Such a situation is depicted in figure 6,
panel A, where St is the foreign firm s’ supply
curve and Sa is the domestic firm ’s aggregate
supply curve. The vertical distance between the
foreign and domestic supply curves represents
the per-unit cost advantage enjoyed by the for­
eign firm. The market supply and demand
curves are shown in panel B. At the initial
market price of Pi, 10 units of the commodity in
question are sold; 3 units are produced domesti­
cally, and 7 are imported.
Assume that because of threatened trade bar­
riers the foreign firm decides to produce in the
United States and consequently loses part of its
competitive advantage. This is shown in panel A
by an upward shift of curve Sf to Sf. The aggre­
gate supply curve in panel B similarly shifts
upward from S to S', and the price rises from Pi
to P2 . At the new price, 9 units of the good are
sold. Consumers now pay a higher amount, indi­
cated by the shaded area P1 P2 a c in panel B, for
these 9 units than before the trade restraints. Of
this amount, P1 P2 a b merely represents an
income transfer from consumers to the firms
and does not represent a net loss to the home
country, since the foreign firm is now part of the
home country. There are, however, two eco­
nomic costs associated with the shift from
importing to domestic production. As with the
tariff and quota examples, there is a loss asso­
ciated with foregone consumption opportuni­
ties, equal to the darkly shaded area a c d in
panel B. There also is a cost associated with a
loss of efficiency in production equal to the
darkly shaded area a e f g h i. Of this amount,
consumers pay a b c, and b e e f g h i comes out
of the producers’ profits.11

11. C orresponding areas in panel A are b ' f g ' h ’ for the
total efficiency loss, b' c 'd ' for the consum ers’ share, and
c 'd 'f 'g ' h 'fo r the share out of profits.

Federal Reserve Bank of Cleveland

Fig. 6

17

Effects of Forced Local Production

Panel A The Firms

Panel B The Market

Price

Price

•S'
S

Q u a n tity

It is also possible that the lack of foreign com­
petition through imports would increase the
bargaining power of organized labor. Some or all
of the higher profits associated with the price
increase (Pi to P2 ) may transfer to workers
through higher wage settlements. The increased
labor power could result in further reductions in
supply, higher transfers from consumers, and
larger net losses to the home country.
It would appear, however, that forced domes­
tic production often does not entail costs as great
as those associated with tariffs or quotas. This
seems especially true in cases such as localcontent requirements where firms transfer only
part of the production process abroad. As the
section on free trade indicated, the larger the



Q u a n tity

pre-trade price differentials among nations, the
greater the benefits of international trade. A
firm, forced to transfer part of its operations
abroad, would shift those that least reduce its
pre-trade competitive edge. In attempting to
maximize its competitive advantage, the multi­
national firm would minimize the efficiency
losses asso ciated w ith forced-dom esticproduction policies.
III.

Conclusion

There are many justifications offered for im­
posing trade restraints or allowing trade incen­
tives. Many are not based on purely economic
criteria, and most, particularly as applied to spe­

18

Economic Review □ Winter 1981-82

cific U.S. industries, are exercises in sophistry.
The distribution among political interests of the
benefits and costs of trade policies probably
explains a great deal about the imposition and
continuation of various trade policies. This arti­
cle has not attempted to analyze the justifica­
tions offered for trade restraints; it accepts that
governments would continue to restrain trade
when it is politically advantageous to do so.
The primary concern here has been the sub­
stitution of trade policies favored under the new
protectionism for the more traditional trade pol­
icies. The new-protectionist trade policies arbi­
trarily transfer real income away from con­
sumers to producers of protected commodities.
While some groups benefit at the expense of
others, the country, nevertheless, incurs a net
loss associated with lost consumption opportun­
ities and increased production inefficiencies.
A complete ranking of the relative costs of
trade policies has not been attempted, but some
general observations can be made. Trade re­
straints such as gentlemen’s agreements, which
allow foreigners to capture a portion of the eco­
nomic rents that the restraints create, seem
more costly than equally restrictive tariffs or
quotas administered by the home country, whose
government would capture those economic rents
through tariff revenue or import-licensing fees.
Anti-dumping and countervailing duties are
merely special-case tariffs, offered special labels
so that they seem less onerous to the public.
Similarly, excessive quality restrictions are
special-case tariffs or quotas, but no revenue
accrues to the home country. Buy-American pol­
icies also function as tariffs of limited scope, but
may be completely ineffective in a competitive
market. Production subsidies do not appear as
costly as tariffs or quotas, but export subsidies
may raise domestic prices, creating pressure for
additional import barriers. Forced domestic pro­
duction generally may be less costly than tariffs
or quotas, because multinational firms would
shift those operations that least reduce their
competitive advantage. In short, the new protec­
tionism is not “new” in terms of efficiency costs
and income transfers. A lemon by any other
name would taste as sour.



R eferen ces

Balassa, Bela. “The ‘New Protectionism’ and
the International Economy "Journal of World
Trade Law, vol. 12, no. 5 (September:October
1978), pp. 409-36.
Bergsten, C. Fred. On the Non-Equivalence of
Import Quotas and “Voluntary” Export Re­
straints. Technical Series Reprint T-009.
Washington: Brookings Institution, 1975.
Bergsten, C. Fred, Thomas 0 . Horst, and
Theodore H. Moran. American Multinationals
and American Interests. Washington: Brook­
ings Institution, 1978, chapters 3 and 4.
Heller, H. Robert. International Trade: Theory
and Empirical Evidence. 2nd edition. New
Jersey: Prentice-Hall, 1973.
Humpage, Owen F. “U.S. Taxation of ForeignSource Corporate Income: A Survey of Issues,”
Economic Review, Federal Reserve Bank of
Cleveland, Winter 1980-81, pp. 1-18.
Krauss, Melvyn B. The New Protectionism, the
Welfare State and International Trade. New
York: New York University Press for the
International Center for Economic Policy
Studies, 1978.
Lowinger, Thomas C. “Discrimination in Gov­
ernment Procurement of Foreign Goods in the
U.S. and Western Europe,” Southern Eco­
nomic Journal, vol. 42, no. 3 Jan u ary 1976),
pp. 451-60.
Luttrell, Clifton B. “The Voluntary Automobile
Import Agreement with Japan—More Protec­
tionism,” Review, Federal Reserve Bank of St.
Louis, vol. 63, no. 9 (November 1981),
pp. 25-30.
McCulloch, Rachel. “Trade and Direct Invest­
ment: Recent Policy Trends,” in Rudiger
Dornbusch and Jacob A. Frenkel, Eds., Inter­
national Economic Policy, Theory and Evi­
dence. Baltimore: Johns Hopkins University
Press, 1979.

Federal Reserve Bank of Cleveland
Morkre, Morris E., and David G. Tarr. The
Effects of Restrictions on United States Im ­
ports: Five Case Studies and Theory. Staff
Report of the Bureau of Economics to the Fed­
eral Trade Commission. Washington: U.S.
Government Printing Office, June 1980.
Richardson, J. David. “The Subsidy Aspects of
a ‘Buy American’ Policy in Government Pur­
chasing,” in Economics of Federal Subsidy
Programs, Part II, U.S. Congress, Joint Eco­
nomic Committee. Washington: U.S. Govern­
ment Printing Office, June 11,1972, pp. 220-43.




19

Stobaugh, Robert B. U.S. Taxation of United
States Manufacturing Abroad: Likely Effects of
Taxing Unremitted Profits. New York: Finan­
cial Executives Research Foundation, 1976,
especially chapter 5.
Tumlir, Jan. “The New Protectionism, Cartels,
and the International Order,” in Ryan C.
Amacher, Gottfried Haberler, and Thomas D.
Willett, Eds., Challenges to a Liberal Interna­
tional Economic Order. Washington: Ameri­
can Enterprise Institute for Public Policy
Research, 1979.

Operational Policies
of Multibank Holding Companies
by Gary Whalen
Multibank holding company growth has been
rapid since the 1970 amendments to the Bank
Holding Company Act of 1956.1 Many states
have permitted multibank holding companies
(MBHCs) for several years, and recent MBHC
authorization in Pennsylvania, Illinois, and West
Virginia suggests that this growth will con­
tinue. Legislators and banking regulators alike
are concerned with the impact of holding com­
pany growth on subsidiary banks, unaffiliated
bank competitors, and the convenience and
needs of the public.
Multibank holding company affiliation gener­
ally has been expected to alter subsidiary bank
behavior relative to independent banks, produc­
ing a variety of impacts. For example, the affilia­
tion of an independent bank with a larger hold­
ing company should allow the subsidiary to
realize various types of economies (technical
and/or pecuniary economies and/or economies

of organization), thereby improving its efficiency
relative to comparable non-affiliate banks.
Reduced costs could benefit consumers through
lower prices and/or higher deposit rates. Access
to the greater resources and expertise of the
holding company may permit subsidiaries to
offer more services than would be possible for
independent banks, another public benefit. Since
a holding company’s sources and uses of funds
are typically more diversified than those of
independent banks, and because MBHCs can
raise capital more easily and more cheaply than
independent banks, an affiliate’s performance
may improve after acquisition because its man­
agement may be able to reduce liquid asset hold­
ings, increase earning assets, and decrease capi­
tal relative to total assets. Again, the public may
benefit from a greater credit flow into the local
area. However, since holding company external
expansion results in increased statewide con­
centration and multi-market linkages, and pos­
sibly a decline in competition, the performance
changes described above may result in private
rather than social benefits.2

1.
These am endm ents subjected single-bank holding com­
panies to the sam e set of regulations applied to m ultibank
holding companies, encouraging holding companies to ac­
quire additional banks. In 1965 there were 48 m ultibank
holding companies controlling 8 percent of deposits in all
commercial banks. By the end of 1970, 111 m ultibank hold­
ing companies controlled 16.2 percent of the commercialbank deposits. At the end of 1979, 330 m ultibank holding
companies existed, controlling approxim ately 15 percent of
all banks, 27 percent of all bank offices, and 33 percent of all
domestic bank deposits.



2.
For a discussion of expected performance im pacts and a
sum m ary of empirical research on these issues, see Drum
(1976) and Board of Governors of the Federal Reserve Sys­
tem (1978).
Gary Whalen is an economist with the Federal Reserve Bank
o f Cleveland.

20

Federal Reserve Bank of Cleveland
Many empirical investigations of the impact
of MBHC affiliation on bank performance have
been undertaken over the past decade. Although
numerous hypothetical performance benefits
have been identified, a very few modest affilia­
tion impacts have been discovered. Affiliate
asset structures have been found to reflect less
liquidity and more risk, as expected. However,
while affiliation appears to enhance revenues,
subsidiary costs generally are higher than those
of independents; hence, the profitability of sub­
sidiaries is not significantly different from that
of independent banks.
However, there is evidence suggesting that
the methodological approach employed in most
of these studies has been responsible for the
inability of researchers to discover appreciable
affiliation-related performance impacts. Typi­
cally, researchers have assumed that holding
company affiliation perse would alter subsidiary
bank performance relative to independent banks.
That is, in most empirical studies, all holding
companies and holding company affiliate banks
are assumed to be homogeneous elements of a
single group. Several researchers have suggested
that this approach is incorrect and seriously
biases the results of these empirical studies.
These researchers maintain that the operational
policies or organizational structure of a particu­
lar multibank holding company influences the
extent to which hypothetical affiliation impacts
are actually manifest (see Weiss 1969 and Law­
rence 1971). More specifically, these researchers
hypothesize that the affiliation impact of any
MBHC on its bank subsidiaries is contingent on
the extent to which subsidiary bank decisions,
policies, and operations are centralized in the
hands of the parent corporation or lead bank.
The contention that a linkage exists between
MBHC structure and performance is important,
because several studies of MBHC operational
policies have revealed that structural centrali­
zation varies widely among companies.3Further,
several researchers have provided a limited
3.
See Weiss (1969), Lawrence (1971), Jesser (1973),
Stodden (1975), and the Association of Bank Holding Com­
panies (1978).



21

amount of empirical evidence suggesting that
affiliation impacts differ significantly across
MBHCs, implying that MBHC structure and
performance might be related.4 One researcher
concludes that offsetting performance variations
attributable to structural differences may be
largely responsible for blurring the impact of
MBHC affiliation on bank performance (see
Fraas 1974).
Only one empirical study of the impact of
MBHC organizational structure on subsidiary
bank performance has been done to date (see
Mayne 1976). Although the study is open to crit­
icism on several grounds, differences in holding
company structural centralization were found
to be systematically related to differences in
several measures of subsidiary bank perfor­
mance.5 Thus, existing evidence suggests that
further research in this area is warranted. Cur­
rent data on holding company operational poli­
cies are required, so that additional, perhaps
more reliable, empirical evidence concerning the
impact of MBHC affiliation on bank perfor-

4. See Fraas (1974), Hoffman (1976), and Mayne (1976).
Mayne alone explicitly tested for the im pact of MBHC stru c ­
tu re on performance, for which she found some sup­
porting evidence.
5. For example, Mayne tested for stru ctu ra l im pacts on
subsidiary bank performance in each year over the 1969-72
interval. She assum ed th at holding companies maximize
subsidiary rath er th an corporate-level profitability and so do
not attem pt to “cap tu re” affiliation-related benefits through
the use of excessive m anagem ent fees. She assum ed MBHC
stru ctu ral invariance over this period. Evidence contained in
the Association of Bank Holding Companies’(ABHC) study
suggests th a t this assum ption may not have been correct.
F u rth er, she assum ed th a t the stru ctu ral benefits generated
by the stru c tu re in place at the outset of the four-year period
were completely realized in this time interval. MBHC seniormanagem ent responses in the ABHC study indicate th at
stru c tu re benefits accrue over time w ith a considerable lag.
In addition, the average asset size of her sam ple holding
company banks was quite sm all (less th an $50 million in
average assets). T here is evidence th a t affiliation produces
net benefits only after subsidiary size exceeds $40 million in
total deposits (see Board of Governors, p. 128). Despite all of
these problems, Mayne found some evidence supporting the
hypothesized relationship. C urrent empirical evidence con­
firm ing the existence of an organizational structure-performance relationship for MBHCs appears in Whalen (1982).

22

Economic Review □ Winter 1981-82

mance can be obtained. Such evidence continues
to be an essential public policy input. Holding
company structural data are of interest for other
reasons. Although there have been several pre­
vious studies of MBHC operational policies,
most were completed in the early 1970s, at the
outset of the period of rapid holding company
expansion. The samples generally were small
and unrepresentative.6A current study utilizing
a broad sample should indicate the validity of
the findings contained in previous studies and
allow structural trends to be detected. Further,
the factors responsible for observed structural
variations have not been adequately explored.
Recently collected information on MBHC
structural centralization is presented in this
paper. In Part I centralization-performance rela­
tionships are discussed, along with the potential
causes of structural variation. Following a brief
discussion of the 1970 structural benchmark
findings of Lawrence, data on current MBHC
operational policies are presented. The method
used to derive quantitative indexes of policyarea centralization from the survey responses is
discussed in Part III. In Part IV structural varia­
tions are analyzed using a summary index of
MBHC centralization, constructed from the in­
dividual policy-area centralization measures.
The summary and conclusions follow.
I.

The Structure-Perform ance
Relationship

Previous studies of MBHC operational policies
were based on the premise that centralization of
certain decisions and operations in holding com­
panies would enhance subsidiary revenues
and/or reduce costs either directly or indirectly.7
Centralization may allow expensive, indivisible
pieces of capital equipment to be fully utilized.
For example, average computation costs tend to
6. While Lawrence’s sample consisted of 52 MBHCs
nationwide, the largest sample size in the other four studies
was 16 companies.
7. A detailed discussion of the potential im pacts of cen­
tralization in MBHCs appears in the Association of Bank
Holding Companies’ study. See also Williamson (1980).



fall as the size and power of the computer
employed are increased. Thus, centralization of
data processing ensures that a large computer
system would be optimally utilized and so should
permit some economies to be realized by the
holding company. Centralization of functions
such as asset and/or liability management also
should generate economies by allowing speciali­
zation and division of labor to be fully exploited.
Efficient use can be made of parent company
staff experts if operations such as securities
portfolio management are centralized rather
than decentralized. Subsidiary capital and
materials costs can be reduced if the larger, more
diversified holding company raises the bulk of
external funds required by subsidiaries and cen­
tralizes purchasing. Centralization of budget­
ing, accounting, and auditing, in conjunction
with the operation of a centralized incentive sys­
tem, provides the parent company with the
capabilities to monitor, evaluate, and stimulate
the performance of subsidiary personnel. Suboptimization with respect to corporate goals can
be detected and prevented. Conversely, in de­
centralized MBHCs, subsidiary banks essentially
operate autonomously; hence, there is no reason
to expect their performance to differ appreciably
from comparable independent banks.
Generally, previous researchers have assumed
that the greater the extent of parent company
centralization, the greater the MBHC affiliation
impacts (see Mayne 1976). That is, the net per­
formance benefits generated by any MBHC are
expected to be positively, although not necessar­
ily linearly, related to its degree of organiza­
tional centralization. This view reflects the
implicit assumption that gross structural bene­
fits exceed structurally related “coordination
costs” as centralization is increased.8 However,

8.
C entralization of any activity in a m ulti-plant firm
necessitates “coordination costs.” For example, centralized
portfolio managem ent requires th a t information be tra n s­
m itted at some cost between the parent company and its
affiliates. T he q u an tity of inform ation required by cen­
tralized decision-m akers and costs incurred are likely to
depend positively (not necessarily monotonically) on the
extent to w hich a given operation is centralized and the
num ber and complexity of decisions th a t m ust be made.

Federal Reserve Bank of Cleveland
Lawrence and others exploring the question of
structural variation among MBHCs have em­
phasized that the net performance benefits gen­
erated by a particular structural alternative,
and so observed structure itself, may vary with
certain firm-specific characteristics and/or the
nature of the particular holding company’s
operating environment.9 These writers have
suggested that realizable structural benefits and
structurally related coordination costs are af­
fected by factors such as the total holding com­
pany size, the relative size of the lead bank and
other bank subsidiaries, the company’s infor­
mation processing capability, the degree of the
company’s geographic dispersion, competitive
pressures, and other factors that influence the
feasibility and/or necessity of adopting a partic­
ular organizational arrangement. These factors
therefore may be related to observed MBHC
structural centralization. However, since only a
limited amount of theoretical and empirical
research on this subject has been done to date,
the exact nature of these relationships cannot
be reliably specified a priori.
II. The L aw rence Study
The 1971 study by Robert Lawrence is of in­
terest for two reasons. First, it was done at the
outset of the period of rapid MBHC growth and
thus serves as a valuable reference point, par­
ticularly in light of his representative sample of
companies. Second, Lawrence converted his
survey data into quantitative indexes of organi­
zational structure and attempted to explain
observed variation in MBHC centralization.
Based on survey responses, Lawrence sub­
jectively determined the extent of parent-company control over, or centralization of, subsidiary
bank decisions in certain operational areas ex­
pected to impact affiliate performance. He clas­
sified each sample company as centralized,
9.
These factors influence the decisional and information
requirem ents and hence coordination costs necessitated by a
given degree of centralization. See the discussion in Law­
rence (1971), pp. 7-11; Longbrake(1974), pp. 2-7; the Associa­
tion of Bank Holding Companies (1978), pp.7-10 and 33-34;
and Jessup (1980), pp. 492-94.



23

moderately centralized, or decentralized in each
policy area, assigning a score of 1 for a rating of
centralized, 2 for moderately centralized, and 3 for
decentralized. He constructed an aggregate cen­
tralization index simply by averaging the policyarea scores.
Lawrence concluded that MBHC centralization
varied greatly by policy area both within and
among companies. He found that holding com­
panies typically centralized capital management,
and the management of subsidiary-bank invest­
ment portfolios (including federal funds trans­
actions). He concluded that correspondent re­
lationships (including loan participations) also
were closely controlled. Lawrence reported that
relatively less parent control was exercised over
subsidiary loan-portfolio management and pric­
ing decisions. Policies in other areas were not
characterized because of structural variation.
Based on his aggregate structural index, he
categorized 23 percent of his sample companies
as centralized, 50 percent as moderately central­
ized, and 27 percent as decentralized.
In an attempt to obtain insight as to the reason
for observed structural variation, Lawrence cor­
related his policy area and aggregate central­
ization measures with MBHC characteristic
variables presumed to affect the net perfor­
mance benefits generated by a particular struc­
tural alternative. The variables employed were
MBHC deposit size, number of subsidiary banks,
geographic extent of MBHC operations, relative
size of the lead bank, and age of the holding
company. He failed to find any significant rela­
tionships between these variables and his struc­
tural indexes.
III.

The Current Study

In November 1979 information on the opera­
tional policies of a sample of MBHCs was col­
lected through the use of a management survey,
based on the one used by Lawrence. Originally,
102 MBHCs were surveyed. The representative
sample consisted of 65 responding companies,
located in 12 states. Although the identities of
the particular respondents are confidential, sum­
mary data concerning the sample companies are

24

Economic Review □ Winter 1981-82

presented in table l . 10
As in the Lawrence study, questions were
asked concerning the extent of parent-company
involvement in, and control over, subsidiary
bank decisions in operational areas in which
MBHC affiliation generally was expected to
impact subsidiary bank performance. The ques­
tions were designed to allow the researcher to
determine the degree of MBHC organizational
centralization in each policy area and, ulti­
mately, to construct quantitative indexes of
structural centralization amenable to statistical
analysis. Unlike the Lawrence survey, however,
the respondents were constrained to answer
each question with either a “yes” or “no.” This
was done to enhance the response rate and to
eliminate the need for the researcher to interpret
subjectively the heterogeneous responses inevi­
tably generated by open-ended questions.
Questions were asked about holding company
involvement in subsidiary bank management,
budget policies, capital management, correspon­
dent relationships, loan participations, federal
funds transactions, securities portfolio manage­
ment, loan portfolio management, liability man­
agement, pricing, and “miscellaneous areas.”
Several questions related to holding company
policies in each of these areas, with the number
asked varying over policy areas. Essentially, the
greater the expected performance impact of cen­
tralization of decisions in an area, the greater
the number of questions asked. For example,
numerous questions concerned MBHC involve­
ment in loan portfolio and capital management.
Fewer questions were asked about the parent
com pany’s role in su b sid iary correspon­
dent relationships.
In general, quantitative policy-area centrali­
zation scores were generated by awarding one
“centralization point” in a particular area for
each response suggesting parent-company in­
volvement in that area. Thus, the greater the
revealed degree of holding company involvement
in any area, the higher the centralization score
10. The average deposit size of the responding companies
in 1979 w as approxim ately $1.5 billion, while the average
num ber of subsidiary banks and bank offices w as 11.3 and
57.4, respectively.



T a b le 1

State

C h a r a c te r is tic s o f th e S a m p le
N um ­
ber
R e­ Total Total
su r­
Resp onse state
state
vey ed sp o n ses rate banks d ep osits

Alabama
Colorado
Florida
M assa­
chusetts
Michigan

5
4
15

5
4
7

5
5

3
2

60.0
40.0

8.5
2.1

29.7
18.9

M issouri
New Jersey
Ohio
Tennessee
Texas

8
7
7
5
18

4
6
4
3
10

50.8
85.7
57.1
60.0
55.5

10.4
11.9
15.6
8.0
6.4

23.3
24.1
24.2
24.8
17.8

Virginia
Wisconsin

9
14

8
9

88.8
64.2

30.5
11.5

60.5
17.9

100.0% 19.8%
100.0
19.8
46.7
20.6

52.9%
47.7
30.3

assigned. Using this procedure, structural scores
were generated for each respondent in each of
the 11 policy areas. Since more questions were
asked, more centralization points could poten­
tially be gained in the key policy areas.
Responses to selected survey questions in
each of the 11 policy areas are detailed in tables 2
through 12.11 Beneath each table are the poten­
tial maximum, mean, standard deviation, and
range of the constructed policy-area centraliza­
tion index. The pattern of responses and the
structural index data indicate structural ten­
dencies and variations.
The responses shown in table 2 and the low
mean policy-area score relative to the potential
maximum indicate th at MBHCs generally do
not attem pt to control subsidiary bank opera­
tions through board member and/or officer over­
lap. The standard deviation of the index is large
relative to the mean, indicating a great deal of
structural variation between companies.
11. Not all questions asked are reported. T his partially
accounts for the divergence between the num ber of ques­
tions in the tables and the maxim um potential centralization
score in any policy area. Additionally, some survey re­
sponses indicating relatively less centralization resulted in a
centralization score of 0.5.

Federal Reserve Bank of Cleveland

T able 2

MBHC G eneral M a n agem en t

Q uestions

Total
affirmative
resp o n ses3

MBHC places its board members
on subsidiary bank boards

43

(66.2)

MBHC places its officers in
subsidiary banks

26

(40.0)

MBHC publishes organizational
m anual detailing subsidiary
management responsibilities

20

(30.8)

Policy-area centralization scores
Potential maximum
Mean
Standard deviation
Range

Table 4

C orrespondent R elationships

Q uestions
MBHC supplies correspondent
services to subsidiaries

57

(87.7)

Use of correspondent services required

38

(58.5)

Use of correspondent services encouraged

18 (27.7)

Correspondent relations w ith non­
affiliates prohibited
Correspondent relations w ith non­
affiliates subject to MBHC approval

5.5
2.1
1.0
0.0 to 5.5

a. N um bers in parentheses represent percent of re­
sponding companies.

Total
affirmative
resp o n ses3

Policy-area centralization scores
Potential maximum
Mean
Standard deviation
Range

7 (10.8)
30

(46.2)

3.0
1.9
0.8
0.0 to 3.0

a. N umbers in parentheses represent percent of re­
sponding companies.

Table 3

Table 5

Capital M anagem ent

Q uestions
MBHC sets subsidiary dividends

Total
affirmative
resp on ses3
64

(98.5)

Liability Management

Questions
MBHC periodically reviews liability
composition of subsidiaries

62

MBHC advises subsidiary with
respect to desired time deposit to
total deposit ratio

39 (60.0)
56 (86.2)

MBHC monitors subsidiary capital
requirem ents and stru ctures

65 (100.0)

MBHC solely responsible for
ensuring capital adequacy

42

(64.6)

MBHC raises all external capital

61

(93.8)

MBHC advises subsidiaries on
negotiable CDs

MBHC decides form in which capital
injected into subsidiaries

54

(83.1)

MBHC approval required before sub­
sidiaries issue CDs

MBHC makes final decision on
subsidiary major capital expenditures

62

(95.4)

MBHC informed when subsidiaries
issue CDs

Policy-area centralization scores
Potential maximum
Mean
Standard deviation
Range

10.0
8.9
0.9
7.0 to 10.0

a. Numbers in parentheses represent percent of re­
sponding companies.




Total
affirmative
responses3

Policy-area centralization scores
Potential maximum
Mean
Standard deviation
Range

(98.4)

5 ( 7.7)
13 (20.0)

6.0
4.1
1.5
0.0 to 6.0

a. Numbers in parentheses represent percent of re­
sponding companies.

26

Economic Review □ Winter 1981-82

Table 6

Loan Participations

Q uestions

Table 7 Federal Funds and D iscount
W indow
Total
affirmative
re sp o n ses3
Q uestions

Subsidiary originating loan requiring
participation is required to offer
it to coaffiliate
Subsidiary originating loan requiring
participation custom arily offers it
to coaffiliate
Subsidiary participation in loans
originated by non-affiliates
prohibited
Subsidiary participation in loan
originated by non-affiliates
subject to MBHC approval
Subsidiaries m ust inform MBHC
w hen participating in loans
originated by non-affiliates
Policy-area centralization scores
Potential maximum
Mean
Standard deviation
Range

Total
affirmative
resp o n ses3

(66.2)

Subsidiaries use MBHC or lead bank
for federal funds transactions

41

(63.1)

(30.8)

MBHC approval required before sub­
sidiaries engage in federal funds
transactions

14

(21.5)

(30.5)

MBHC or lead bank centrally affects
federal funds transactions for
all subsidiaries

32

(49.2)

14 (21.5)

Prior consultation w ith MBHC
required before subsidiary
borrows at discount window

26

(40.0)

18 (27.7)

MBHC approval necessary before
subsidiary borrows at discount
window

9

(13.8)

Policy-area centralization scores
Potential maximum
Mean
Standard deviation
Range

6.0
3.0
2.9
0.0 to 6.0

43

20

20

3.5
2.5
0.9
0.5 to 3.5

a. N um bers in parentheses represent percent of responding companies.

a. N um bers in parentheses represent percent of re­
sponding companies.

The high proportion of affirmative responses
to questions about capital management policies
suggests that MBHCs typically exert central­
ized control over subsidiary bank operations in
this area (see table 3). Comparison of the mean
policy-area score with the potential maximum
confirms this finding. Further, the small size of
the standard deviation of the structural index
relative to the mean suggests little structural
variation in this area.
MBHCs appear to exercise somewhat less, but
still considerable, control over subsidiary bank
correspondent relationships, liability manage­
ment, and loan participation policies (see tables
4, 5, and 6). Centralization appears to be both
greater and less variable in the latter two areas.
Centralization policies in the area of federal
funds transactions follow a similar pattern (see
table 7). MBHCs appear to exercise at least a

moderate amount of control over subsidiary
bank operations in this area. However, the cen­
tralization index standard deviation is large rel­
ative to the mean, indicating structural varia­
tion. Further, responses in this area constitute
evidence that MBHC centralization generally
has increased since Lawrence’s study. None of
Lawrence’s sample companies reported that
advance approval was required before a sub­
sidiary bank could engage in federal funds trans­
actions; 14 MBHCs indicated that such approval
was required (see Lawrence 1971).
Security portfolio management appears to be
relatively centralized (see table 8). Virtually all
companies report substantial involvement in
this area. This is reflected by the proximity
between the index mean and potential max­
imum. Structural variation does not appear to
be considerable.




Federal Reserve Bank of Cleveland

T able 8

S e c u r itie s P ortfolio M an a g em en t

Q uestions
MBHC offers advice on securities
investm ents to affiliates
MBHC suggests proportion of funds
allocated to investm ents
vs. loans
MBHC specifies maximum or mimmum am ount of state and local
issues to be held
MBHC handles buy and sell orders
for all subsidiaries’ securities
transactions
MBHC handles securities portfolio
m anagement entirely for
subsidiaries

Total
affirmative
resp on ses3

62

(95.4)

55

48

45

38

(84.6)

(73.8)

(69.2)

24

(36.9)

MBHC prohibits subsidiaries
from obtaining portfolio advice
from non-affiliates

49

(75.4)

Questions

Total
affirmative
responses3

MBHC periodically reviews schedule
of subsidiary bank-loan
interest rates

50

MBHC suggests pricing loans at
floating vs. fixed rates of interest
or vice versa

53 (81.5)

MBHC offers advice on service
changes, deposit interest rates,
fees, etc.

55 (84.6)

MBHC makes final decision on prices
charged at subsidiary banks

10 (27.8)

(76.9)

Prices set uniformly throughout
MBHC system

6 ( 9.2)

Policy-area centralization scores
Potential maximum
Mean
Standard deviation
Range

7.5
3.7
1.7
0.0 to 7.5

a. Numbers in parentheses represent percent of responding companies.

11.0
8.2
2.9
0.0 to 11.0

a. Numbers in parentheses represent percent of responding companies.

MBHCs appear to exert a moderate amount of
control over subsidiary bank pricing decisions
(see table 9). In particular, holding company
policies in this area appear to be much more cen­
tralized in 1979 than they were in 1970. Lawrence
rated companies as centralized in this area (16 of
52 companies) if they only reviewed subsidiary
bank interest rates. In contrast, 50 of 65 com­
panies in 1979 reviewed subsidiary interest
rates, and 10 reported that the holding company
made the final decision on the prices to
be charged.
MBHC control over subsidiary budget policies
appears to be highly centralized (see table 10).



Pricing Policies

(58.5)

MBHC manages security holdings
of subsidiaries collectively, as
single portfolio

Policy-area centralization scores
Potential maximum
Mean
Standard deviation
Range

Table 9

27

Little structural variation in this area is evident.
The responses in table 11 suggest that MBHCs
exert at least a moderate amount of centralized
control over subsidiary bank loan portfolio
management. The evidence indicates that
MBHC policies in this area can no longer be cate­
gorized as relatively decentralized as they
were by Lawrence.
Finally, centralization of other operations and
services appears to vary (see table 12). Data pro­
cessing, auditing, and purchasing seem to be
centralized. Most companies also appear to
operate a centralized incentive system. Trust
activities, purchasing, and accounting seem to
be centralized less often. Centralization seems
to have increased in some of these areas over the
decade as well. For example, only 38 percent of
Lawrence’s sample indicated that trust opera­
tions were centralized in 1970; 58 percent of the

28

Economic Review □ Winter 1981-82

sample reported centralization in this area in
1979 (see Lawrence 1971).
IV.

Structural Variation

Structural variation was explored by regress­
ing an aggregate measure of MBHC centraliza­
tion on variables expected to influence the net
benefits attributable to a particular organiza­
tional alternative. The final form of the esti­
mated regression appears in table 13.12 The
summary centralization index, CT, was formed
by simply summing the 11 policy-area central­
ization scores.13 The mean and standard de­
viation of this measure, as well as those of the
independent variables employed, appear in the
table. Comparison of the standard deviation of
this structural measure relative to its mean
suggests that aggregate centralization, as well
as policy-area centralization, varies widely
among holding companies.
The /-statistics in table 13 indicate that the
coefficients of all of the independent variables
used in the regression are significant. Similarly,
the significant F-statistic suggests that the
explanatory power of the estimated equation is
considerable.
The regression results reveal a quadratic sizecentralization relationship, centralization rising
with MBHC size until holding company total
deposits reach approximately $2.2 billion.
Beyond that point, size and centralization are
inversely related. Evidently, structurally related
“coordination costs” rise relative to realizable

12. Additional explanatory variables (e.g., a geographic
dispersion variable, a grow th rate variable, and holding
company age) were employed in prelim inary runs. All were
insignificant and so were dropped from the estim ated
equation.
13. An equally w eighted sum m ary index also was con­
structed by sum m ing the 11 policy indexes after each had
been divided by the policy area potential m aximum . T hus,
all policy area indexes were scaled to vary between 0 and 1.
The equally w eighted sum m ary index was highly correlated
w ith C T (the correlation coefficient w as approximately 0.9),
and regression resu lts were virtually identical w hen this
m easure was employed as the dependent variable. T hus,
these results were not reported.



T a b le 1 0

B u d g e t P o lic ie s

Q uestions

Total
affirmative
re sp o n ses3

MBHC subsidiaries m ust subm it budgets

63

(96.9)

MBHC approval of subsidiary
budgets required

56

(86.2)

MBHC monitors budget variances

63

(96.9)

MBHC evaluates subsidiary CEOs
relative to budgeted figures

59

(90.8)

Policy-area centralization scores
Potential maximum
Mean
Standard deviation
Range

5.0
4.5
1.0
0.0 to 5.0

a. N umbers in parentheses represent percent of re­
sponding companies.

structural benefits as MBHC size increases,
ceteris paribus.
A negative relationship was discovered be­
tween the subsidiary size configuration vari­
able, H, and MBHC centralization. The more
equal the sizes of its subsidiary banks, the lower
the value of H. Thus, subsidiary size equality
and the degree of holding company central­
ization are positively related. Centralization
thus may be less costly and/or more necessary
when all bank subsidiaries are relatively homo­
geneous in terms of size.
The positive coefficient of the LBSIZE vari­
able suggests that the larger the lead bank rela­
tive to the other holding company banks, the
greater the degree of MBHC centralization. Pre­
sumably, the large lead banks have extensive
managerial and financial resources and can pro­
vide strong support to smaller affiliates, all of
which could lead to some form of centralization.
The coefficient on the information-processing
dummy MISDUM was also positive, indicating
that holding company centralization and information-processing sophistication are directly
related. Operation of a management-information
system evidently lowers structurally related
“coordination costs,” ceteris paribus.

Federal Reserve Bank of Cleveland

Table 11

Table 12
Services

Loan Portfolio M anagem ent

Questions

M iscellaneous Centralized

Total
affirmative
responses8
Questions

MBHC publishes loan policies
binding on all affiliates

30 (46.2)

Total
affirmative
responses8

MBHC has centralized incentive
program

52

(80.0)

20 (30.8)

MBHC has centralized systems and
procedures group

41

(63.1)

MBHC suggests a loan-to-deposit
ratio for each bank

55 (84.6)

MBHC has central purchasing
department

40 (61.5)

MBHC advises affiliates on maturity
structure of loan portfolios

42

MBHC has central printing
department

27

(41.5)

MBHC advises affiliates on “mix”
of loan portfolios

59 (90.8)

MBHC centralized data processing
available

61

(93.8)

Use of MBHC data-processing
facilities required

52

(80.2)

MBHC has central audit department

62

(95.4)

MBHC has centralized trust
operations

38

(59.5)

Demand deposit/time deposit ac­
counting centralized

35

(53.8)

General ledger accounting
centralized

50 (76.9)

MBHC has management information
system

35

Subsidiary banks must publish loan
guidelines subject to holding
company approval

MBHC monitors amount of loans
made at floating vs. fixed rates
of interest
MBHC advises subsidiaries on
non-price loan terms
Subsidiaries inform MBHCs when
lines of credit extended
MBHC requires approval of
subsidiary credit-line extensions
Policy-area centralization scores
Potential maximum
Mean
Standard deviation
Range

(64.6)

45 (69.2)
51

(78.5)

24 (36.9)
9 (13.8)

11.5
7.4
2.4
0.5 to 11.5

a. N um bers in parentheses represent percent of re­
sponding companies.

Finally, the lim ited-area and statew ide
branching dummy variables exhibit positive
coefficients, indicating that branching freedom
and MBHC centralization are directly related.
This finding can be interpreted as evidence of a
positive association between competitive pres­
sures and holding company centralization, as­
suming the intensity of competition and branch­
ing freedom are directly related.
V.

Sum m ary and Conclusion

The survey findings indicate that MBHC
organizational structures remain diverse. Oper


29

Policy-area centralization scores
Potential maximum
Mean
Standard deviation
Range

(53.8)

34.5
22.1
6.7
4.0 to 33.0

a. N um bers in parentheses represent percent of re­
sponding companies.

ational policies appear to vary within and among
companies by policy area. In general, MBHCs
typically exercise relatively centralized control
over subsidiary bank budgets, capital manage­
ment, and securities and loan portfolio manage­
ment policies. Somewhat less, but still con­
siderable control is exercised in the areas of
correspondent relationships, loan participations,
federal funds transactions, liability management,

30

Economic Review □ Winter 1981-82

Table 13
Variable

R egression of Sum mary Centralization Index on P otential D eterm inan ts3
SIZE

SIZESQ

H

-l.ixio-6

LBSIZE

MISDUM

BR D U M l

BRDUM 2

Constant
65.01

0.0049

-34.5655

1.6309

8.0987

6.0864

10.3847

/-Statistic

1.87*

2.66**

3.36**

3.42**

2.89**

1.88*

2.68**

Mean

1.49X103

4.39X106

0.411

3.11

0.539

0.565

0.226

10.61X106

0.212

5.83

0.502

0.500

0.422

Standard
deviation

'fe
X
00

Coefficient

F

R2

7.29 0.42

a. T he mean and the standard deviation of the sum m ary centralization index, CT, are 68.7 and 13.05, respectively.
* Significant at 10 percent level—two-tail test.
** Significant at 5 percent level—two-tail test.

V ariables U sed in Estim ated Equations:
CT:
SIZE :
SIZE SQ :

Sum of 11 policy-area centralization indexes.
Holding company total deposit size, year-end, 1978 (in millions).
The square of SIZE.

H:

Subsidiary size variation m easure. The sum of the squared shares of holding company total deposits held by
each subsidiary bank.

LB SIZE :

Total deposits held by the lead holding company bank relative to total deposits in all other subsidiary banks.

M ISD U M :

Equal to 1 if holding company reported it had a management-information system; equal to 0 otherwise.

B R D U M l:

Equal to 1 if holding company operated in limited branching state; equal to 0 otherwise.

BRDUM2:

Equal to 1 if holding company operated in a statew ide branching state; equal to 0 otherwise.

and pricing. It should be noted that in the empir­
ical studies in which structural differentials
have been ignored, MBHC affiliation is consist­
ently found to impact subsidiary bank asset
allocation and leverage. This is suggestive evi­
dence that centralization in the areas of capital
management and securities and loan portfolio
management is responsible for these differences
in performance. Further, the data reveal that
MBHC centralization, on average, has increased
over the last decade. This trend also suggests
that centralization and performance may be pos­
itively related. The evidenced levels of centrali­
zation indicate that MBHCs may be effective
substitutes for branch systems.
The regression results provide some insight
on the possible causes of observed structural
variations between different holding companies.
Counter to the earlier findings of Lawrence, it
seems that MBHC structural policies can be
estimated or predicted from available data.
The evidence indicates that MBHC total size



and centralization become inversely related after
a critical size threshold is reached. Assuming
that parent company centralization has a sys­
tematic effect on subsidiary bank performance,
the implication of this finding is that increases
in statewide concentration and multi-market
linkages resulting from external expansion of
the largest holding companies may not be a
cause for concern, since these companies typi­
cally exercise less centralized control over the
operations of their bank affiliates.
The structural information presented in this
study clearly implies that it is incorrect to view
all holding companies and their bank subsidiaries
as homogeneous elements of a single group, the
standard practice in previous affiliation impact
studies of holding companies. If MBHC struc­
ture does influence performance, reliable empir­
ical evidence on the affiliation impacts of hold­
ing companies can only be obtained from studies
in which differences in holding company cen­
tralization are explicitly taken into account.

Federal Reserve Bank of Cleveland
R eferen ces
Association of Bank Holding Companies. Bank
Holding Company Centralization Policies.
Washington, D.C.: Golembe Associates, Inc.,
February 1978.
Board of Governors of the Federal Reserve Sys­
tem .“The Bank Holding Company Movement
to 1978: A Compendium.” Staff Study. Wash­
ington, D.C.: Board of Governors, September
1978.
Drum, Dale S. “MBHCs: Evidence after Two
Decades of Regulation,” Business Conditions,
Federal Reserve Bank of Chicago, December
1976, pp. 3-15.
Fraas, A rthur G. “The Performance of Individ­
ual Bank Holding Companies.” Staff Study
No. 84. Washington, D.C.: Board of Gover­
nors of the Federal Reserve System, 1974.
Hoffman, Stuart G. “The Impact of Holding
Company Affiliation on Bank Performance: A
Case Study of Two Florida Multibank Hold­
ing Companies.” Working Paper Series. Fed­
eral Reserve Bank of Atlanta, January 1976.
Jesser, Edward A., Jr., and Kenneth H. Fisher.
“Guidelines for Bank Holding Company
Management,” Bankers Magazine, vol. 156,
no. 3 (Summer 1973), pp. 13-20.




31

Lawrence, Robert J. “Operating Policies of Bank
Holding Companies: Part I.” Staff Study No.
59. Washington, D.C.: Board of Governors of
the Federal Reserve System, April 1971.
Longbrake, William A. “The Differential Effects
of Single-Plant, Multi-Plant, and Multi-Firm
Organizational Forms on Cost Efficiency in
Commercial Banking.” Working Paper No.
74-7. Washington, D.C.: Federal Deposit In­
surance Corporation, 1974.
Mayne, Lucille S. “Management Policies of Bank
Holding Companies and Bank Performance,”
Journal of Bank Research, vol. 7, no. 1 (Spring
1976), pp. 37-48.
Stodden, John R. “Survey of the Operating Poli­
cies and Performance of Texas Multibank
Holding Companies: Preliminary Findings,”
in Conference on Bank Structure and Competi­
tion, Federal Reserve Bank of Chicago, 1975.
Weiss, Steven J. “Bank Holding Companies and
Public Policy,” New England Economic Re­
view, Federal Reserve Bank of Boston, Janu­
ary/February 1969, pp. 3-29.
Whalen, Gary. “Multibank Holding Company
Organizational Structure and Performance.”
Working Paper 8201. Federal Reserve Bank of
Cleveland, March 1982.
Williamson, Dan. “Dozens of Portfolios—One
Investment Policy,” ABA Banking Journal,
vol. 72, no. 2 (February 1980), pp. 56-66.

Gary Whalen, “Multibank Holding Company
O rg an ization al S tru ctu re and P er fo r­
m an ce,” Working Paper 8201, March 1982,
30 pp. Bibliography.

Multibank holding company growth has been
rapid since 1970. Recent passage of legislation au­
thorizing multibank holding companies (MBHCs)
in Pennsylvania, Illinois, and West Virginia and
similar proposals in other states suggest that
this growth will continue. MBHC affiliation
generally has been expected to alter the perfor­
mance of subsidiary banks relative to indepen­
dent banks, thereby impacting consumer welfare
and bank competition and soundness. The net
social benefits produced by holding company
expansion are debatable. Many empirical investi­
gations of the impact of MBHC affiliation on
bank performance have been undertaken over
the past decade. Contrary to a priori expecta­
tions, very few modest affiliation impacts have
been discovered. Affiliate asset structures have
been found to reflect less liquidity and more risk.
While affiliation appears to enhance revenues,
subsidiary costs generally are higher than those
of independents; hence, their profitability is
not sig n ifican tly different from th a t of
independent banks.
There is evidence suggesting that the metho­
dological approach employed in most of these
studies has been responsible for the failure of
researchers to discover appreciable affiliationrelated performance impacts. Generally, re­
searchers have assumed that holding company
affiliation per se would alter subsidiary perfor­
mance relative to independent banks. Several
w riters have countered that MBHC operational
policies—and more specifically, the extent to
which subsidiary bank decisions and operations
are centralized in the hands of the parent corpo­
ration or lead bank—influence the degree to
which hypothetical affiliation impacts are actu­
ally manifest. These researchers have supplied
a considerable amount of empirical evidence

suggesting that MBHC structural centralization
varies widely among companies. The implica­
tion is that offsetting performance variations
attributable to structural differences may be
responsible for blurring the impact of MBHC
affiliation on bank performance.
Researchers have suggested that MBHCs may
attempt to maximize corporate rather than
subsidiary-level performance; hence, the parent
may attem pt to “capture,” either totally or par­
tially, affiliation benefits realized by bank sub­
sidiaries through the use of intra-company reve­
nue transfers. If this were the case, beneficial
affiliation impacts, particularly lower costs re­
sulting from scale economies, would not be
detectable at the subsidiary bank level.
This study represents an attem pt to deter­
mine empirically w hether differences in MBHC
organizational centralization are systematically
related to differences in bank affiliate perfor­
mance and, through this channel, consolidated
holding company performance. The sample is
cross-sectional, consisting of 62 MBHCs whose
management responded to a survey of opera­
tional policies in November 1979. Quantitative
indexes of the organizational centralization of
the sample companies, derived from the survey
data, were related to summary measures of hold­
ing company profitability, and a positive, signif­
icant relationship was found. Given that MBHC
organizational structure varies considerably,
the analysis implies that it is inappropriate to
treat all holding companies and their subsid­
iaries as members of a single, homogeneous
group. Public policy governing future intra- and
interstate expansion by MBHCs should be guided
by empirical evidence obtained from studies in
which differences in MBHC organizational
structure are explicitly taken into account.

Copies of this working paper are available from the Federal Reserve Bank of Cleveland, Research Department, P.O.
Box 6387, Cleveland, OH 44101.



32