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Economic
Ileview
Federal Reserve Bank
of San Francisco
Spring 1991

Chan Huh
and Bharat Trehan

Number 2

Real Business Cycles: A Selective Survey
Japanese Capital Flows in the 1980s

Reuven Glick

Elizabeth S. Laderman
and Randall 1. Pozdena

Interstate Banking and Competition:
Evidence from the Behavior of Stock Returns

Table off Contents

Real Business Cycles: A Selective Survey . 00»e e«,0«,s »0a 0„ e. 0000„«0000

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Chan Huh and Bharat Trehan

Japanese Capital Flows in the 19!§0§ .. 0.«,».. „. 0». 0„ .. . 0».»„. 00•. . »„ 0„.».«, M
Reuven Click

Interstate Banking and Competition:
Evidence from the Behavior of Stock Returns 000., <>0„ „» 000„

*0»0 0

„ „ 0„ 32

Elizabeth §, Laderman and Randall J. Pozdena

Federal Reserve B ank o f San Francisco

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E conom ic R eview / Spring 1991

Real Business Cycles: A Selective Survey

Chan Huh and Bharat Trehan
Economist and Senior Economist, Federal Reserve
Bank of San Francisco. The authors would like to thank the
members of the editorial committee, Fred Furlong, Ramon
Moreno, and Brian Motley, and also John Judd, Carl
Walsh, and participants at an in-house FRBSF seminar for
helpfUl comments.

It is now more than ten years since the publication of
Kydland and Prescott's first paper on real business cycles
(RBC). RBC theories rationalize fluctuations in key real
macro variables as the natural outcome ofthe competitive
economy where individuals make optimal, intertemporal
resource allocation decisions in response to stochastic
shifts in the production technology. We use a simple model
to bring out the salient features of this methodology and
present a selective survey of work in this area over the
last decade.

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It is now more than ten years since the publication of
Kydland and Prescott's first paper on real business cycles. I
Their early work has stimulated an impressive body of
research. This paper presents a selective survey of the
developments in this field over this period.
There can be different ways of describing the distinguishing tenets of real business cycle (RBC) theories. For
instance, Stockman (1988, p. 24) says, "the purpose of real
business cycle (RBC) models is to explain aggregate
fluctuations in business cycles without reference to monetary policy." Perhaps more fundamentally, it is the following central implication of RBC theories that has attracted
attention: Fluctuations in aggregate output, as well as
employment, are not a manifestation of coordination failure in some markets, but a natural outcome of the competitive economy where rational individuals make optimal,
intertemporal resource allocation decisions in response to
stochastic shifts in the production function.
Another aspect of these models is the fact that they are
dynamic, general equilibrium models of the economy, and
they generate empirical predictions for a wide array of
macroeconomic variables. This is in contrast to most
earlier analyses, which focused upon describing the behavior of a subset of the economy. Thus, these models aim
to fulfill Lucas's (1977) requirement for understanding
business cycles: "One exhibits understanding of business
cycles by constructing a model in the most literal sense: a
fully articulated artificial economy which behaves through
time so as to imitate closely the time series behavior of
actual economics" [sic) (p. 11).
In a sense, RBC models are the descendants of the
models of Lucas (1975) and Barro (1976). Elements that
are common to these models include the role of intertemporal substitution, the emphasis on individual optimization, as well as the requirement that markets clear-in the
sense that no unexploited gains from trade are permitted.
These elements distinguish both kinds of models from the
traditional Keynesian theories of the business cycle.
However, RBC models diverge sharply from LucasBarro type models when it comes to the sources of macro-

economic fluctuations. Whereas the earlier models focused
on the role of monetary shocks in causing business cycles,
RBC models assign the primary role to shocks to production technology. It is this combination of assumptions
about the economy's structure (i.e., optimizing individuals, perfect competition, and clearing markets) and the
source of shocks (primarily, shocks to technology) that
suggests that macroeconomic fluctuations represent optimal responses, and-in the absence of externalities-also
makes it difficult to see how stabilization policy can lead to
improvements in welfare.
RBC models also differ from the business cycle models
of Lucas and Barro in the production technology they
assume. Specifically, these models employ the production
structure contained in the Solow growth model. However,
the fact that these models allow endogenous saving and

labor supply decisions places fewer restnctlOns upon
the dynamic behavior of key macroeconomic variables
(such as income, investment, etc.) than traditional growth
models do, and therefore allows us to study businesscycle-like movements in this artificial economy.
This paper is organized as follows. Section I lays out a
simple, intertemporal model to illustrate the key elements
of an RBC model. This model is then solved and the
solutions used to derive relationships between different
variables. The next section discusses how the predictions
from an artificial RBC economy are compared to the data
and how well these models perform. Section III surveys
research aimed at incorporating money into these models.
Section IV reviews some of the criticisms made against
these models, while the last section offers an appraisal and
some concluding comments.

I. A Simple Intertemporal Model
We will analyze a simple two-period model, where
many agents with identical preferences and endowments
reside in the economy. This makes the economy-wide
equilibrium outcome exactly the same as that for the
individual, and allows us to analyze the behavior of
the economy in terms of the behavior of a representative
agent. Assume that each individual's preferences can be
described by

where C j and lj denote consumption and leisure in period i. 2
For simplicity we assume that 'Y = I, so that the utility
function becomes
(1)

where A> o. Each individual makes allocation decisions
in periods one and two to maximize the two-period objective function,
(1)'

where f3 is the rate at which individuals discount tomorrow's utility. For simplicity, we set f3 = 1 below.
We assume that each individual begins period 1 with an
endowment of k1 units of capital. Each individual has to
choose how much to consume and invest (c 1 , i1 ), and how
much time to spend in leisure or work (l1' n 1). These
decisions will depend on the prices of leisure (that is, the
wage rate) and rental capital, determined in the factor
market and taken as given by individuals in the economy.

Equations (2) and (3) embody these decisions and the
relevant constraints on each set of decisions:
(2)
(3)

Here WI is the wage rate and r 1 is the capital rental rate.
Equation (2) states that the sum of the individual's consumption and investment (or saving) must equal the sum of
her income from labor and capital. Equation (3) simply
normalizes total hours to equal l.
The individual does not invest in capital fonnation in
period 2. However, she still has to make the leisure-labor
choice. Equations (4) and (5) describe these decisions for
period two:
(4)
(5)

The evolution of the individual's capital stock from period
I to 2 is given by

(6)
where 8 denotes the depreciation rate for one period. For
simplicity, we assume that capital is used up each period,
so 8 is set to one. Consequently, i 1 = k2 in our model.
Consumers make allocation decisions to maximize (1)'
subject to the constraints (2)-(6). This will give rise to the
following set of equations that describe the necessary
conditions for the consumer's optimum:

Economic Review / Spring 1991

aU I

aC I

- Al

wIl..l

= 0

For the next stage we exploit the structure of the model
economy. First, the constant returns to scale technology
and perfect competition assumptions imply that factor
prices will be set equal to marginal products. Thus, in our
simple model, we will obtain Wi = 1 and r i = Zi' for
i
1, 2.
These conditions, together with the first order conditions above (equation (7», imply certain specific relationships between the decision variables (that is, C I , n l , ii'
etc). Thus, we obtain

atI I

(7)

- Al

aU 2

aC2
aU 2

r 2 A2 = 0

- 1.. 2

w 2 A2

= 0

(lOa)

Here A!, 1.. 2 are Lagrange multipliers associated with
constraints (2) and (4), respectively, and measure the
shadow price of consumption in the two periods.
Assume that there are as many firms as individuals.
Each firm maximizes one-period profit, given by
(8)

where Y denotes the firm's output, while N and K respectively denote the labor and capital employed by the firm.
Firms are assumed to employ input factors in competitive
factor markets, so that factor prices (measured here in
terms of output) are taken as given. These firms employ an
identical production technology given by the constant
elasticity of substitution (CES) function
-

Y = [u 1N-P

u 2 (Kz)-P]

where the good Y can either be consumed or invested. Here
U I and U 2 are the respective shares oflabor and capital, and
p is the elasticity of substitution between the two. The Zj s
denote capital specific technology shocks. For simplicity
again, we assume that U I = U 2 = - P = 1, so that the
production function becomes

(lOb)
for i = 1,2.
The first equation shows the equilibrium tradeoff between
consumption today and tomorrow. It states that in equilibrium the marginal utility of $1 of consumption today
must equal the marginal utility of $r 2 of consumption
tomorrow. Similarly, (lOb) presents the equilibrium tradeoff between consumption and leisure. This tradeoff is
determined by the parameter A, which represents the
utility derived from leisure relative to that derived from
consumption. The equation shows that at the optimum the
individual equates the marginal utility of consumption
with the marginal utility of leisure.
Then, we impose the market clearing conditions. Specifically, in equilibrium the demands for labor and capital
will equal the respective supplies (i.e., N = nand K = k),
and total output will be exhausted (i. e. ,y = c + k). As a
result, we obtain a system of equations that describes the
evolution of the equilibrium values over time:

(9)

We further assume that there is no uncertainty in this
economy, so that ZI and Z2 are known when agents make
decisions at the beginning of period 1. 4
Given this structure for the economy, our aim is to derive
a system of equations that expresses the endogenous variables as functions of the exogenous technology shocks and
predetermined capital stock variables that describe the
state of the economy. Solving the first order conditions
(equation (7») will give rise to individual decision rules
that relate individual consumption-saving and leisurelabor decisions to the set of variables that are taken to be
exogenous to an individual consumer, such as the wage and
capital rental rates for both periods and aggregate capital
stocks in each period.

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(11)

+ A(l
D I (D 2 + Z2 I)

= DI

i l = k2

n 2 = D I {2

(D 2

+ A(l

Z2 1 )
- Z2D2)}

where D I
1/2(1 + A) and D 2 = (1 + kl ZI)' We now
use our model and these results to discuss some of the key
issues in the RBC literature.

Intertemporal Choices
The intertemporal nature of the decision is immediately
clear in (11). The equilibrium outcome of the first period is
directly dependent on the state of the economy in the

second period, and vice versa. The reason for these intertemporal linkages is easily seen from (lOa). Because
the individual equates the marginal utility of consumption
in both time periods, any change in consumption (or
in consumption possibilities) in one period will also affect consumption in the second. For similar reasons, any
change in.leisure in one period will also lead to a change in
leisure in the next period.
It is easiest to understand the adjustments taking place
by examining how individuals react to the two technology
shocks in the model. Consider first the response to a
change in Z\ • From (11) we have

the wage rate. This is because an increase in the productivity oftomorrow's capital stock makes it desirable to have a
larger capital stock tomorrow. One way to increase tomorrow's capital stock is to increase work effort and produce
more today, so that more can be invested.
The other way is to reduce consumption today, since the
rewards to deferring consumption have gone up. Specifically,
aC l

aZ2

aZ l
an2

aZ l

Recall that the Zj s affect the productivity of capital (and in
equilibrium equal the real interest rate). Further, since the
productivity of capital is independent of labor supply, a
higher Zl is equivalent to getting a larger endowment of
capital in the first period. In other words, an increase in Zl
has a pure wealth effect. Theory tells us that individuals
should react by reducing labor supply in both periods. (l2)
shows that a large realization of Zl unambiguously lowers
n 1 • It will also lower n2 as long as Z2 is positive, a
requirement that does not seem too stringent when it is
recalled that Z2 (= r 2) is the gross rate of return on
investing in the first period.
Higher wealth should also imply an increase in consumption. In our model, (lOa) shows that any change in the
equilibrium level of leisure (and hence labor supply) must
be accompanied by a change in consumption. This can be
confirmed from (ll) as well

aZ2
Thus, an increase in the productivity of tomorrow's capital
stock leads to increased investment today; this higher
investment is obtained by reducing consumption and by
increasing work effort.
Thus, changes in intertemporal opportunities cause individuals to alter both consumption and leisure. These
intertemporal considerations remain central as the time
horizon is extended from our simple two-period framework
to the infinite horizon models typically used in RBC
analysis.

Fluctuations in Output
When the solutions for n 1 ' n2 , and i 1 (shown in (ll» are
substituted into (8), we can write equilibrium outputs of
periods one and two (Y\, Y2 ) as functions of the state
variables. 5 Differentiating these expressions leads to
aY

-al

= (2

aZ l

aY2

anI

AD 1

aZ2

an 2

aZ2
Thus, a large Z2 unambiguously lowers n2 because of the
wealth effect. However, it has the opposite effect on n1 •
Note that this change in n\ occurs without any change in

aZ2

---,----=--

D\D 2

D\k\Z2 > O.

The effect of an increase in Z2' however, is quite different
from that of an increase in z\. Again from (11)

+ A)D\k 1

and

aC l

aC 2

anI

(l2)

(2 +A)z~

The equations show that output in the two periods reacts
differently to each shock, that is to say, ay\/ aZ i =1= ay2 / az i ,
for i = 1, 2. So, output in our model economy will
fluctuate over the two periods, where the particular shape is
determined by the realizations of the exogenous technology shocks in both periods. Notice that the differential
response of output over the two periods is perfectly compatible with the fully informed, optimizing behavior of
agents in the economy. In the context of our model,

Economic Review / Spring 1991

attempts to offset this response (that is, attempts to "stabilize" output) will have adverse welfare consequences. That
is because the fluctuations in output are the result of
individuals' utility maximizing decisions about consumption and leisure over time, and attempts to alter these
decisions will only force individuals to make choices that
were initially rejected as being less desirable.

Consumption and Investment Volatility
Since no investment takes place in the second period, we
will examine the consumption-investment (savings) decision of the first period to see what our model says about the
relative volatility of consumption and investment. From
(11) we obtain

and

so that

11\
111

+ k1z l ) + 1
>1.
z2(1 + k1z l ) - 1

z2(l

Carrying out the same exercise with respect to
leads to:

also

These semi-elasticities measure how much individuals
modify their optimal consumption-saving allocations in
response to a productivity shock either today or in the
future. These results show that investment will be more
responsive to external shocks than consumption in this
economy, as long as Z2 is no smaller than 1. (This restriction
implies that in the worst states of the world the decision to
invest is equivalent to a decision to hold nonproductive

inventories, since firms always get back what they invest.)
The investment series will continue to be more volatile
than the consumption series over time when the time
horizon is extended in our economy.
The fundamental reason that consumption is less volatile than investment can be found in the basic properties of
the utility function that describes preferences in our model
economy. The specification of the utility function (1) implies that a typical person in the model economy does not
regard. consumption in different periods (periods one and
two) as perfect substitutes. In other words, the individual
wants to consume in both periods. If this were not the case,
a small change in the relative advantage to consuming in
any period would lead the individual to switch all consumption to that period. 6 One response to this desire to
smooth consumption would be to smooth production as
well. However, the returns to production, and to the
ownership of capital, can vary widely over time, so investment will tend to be more volatile.
The mechanics of this argument are best understood in
terms of the model discussed above. Consider, first, an
increase in ZI' Recall that this implies an increase in
wealth. The individual's response is to work less and
consume more in both periods. However, the direct effect
of working less in the second period would be to reduce
second period output and, therefore, second period consumption. Consequently, in order to smooth consumption
the individual must raise investment in period 1 by more
than the change in consumption.
An increase in Z2 represents an increase in the rate of
return on capital in the second period. As discussed above,
individuals react to this increase by raising labor supply
today and lowering consumption. So, period 1 output goes
up while consumption declines, that is to say, investment
rises by more than the fall in consumption.
Our finding that investment is more volatile than consumption is one of the widely recognized key stylized facts
of the U. S. and other economies, and, as we discuss below,
has been replicated by many different RBC models.

II. Matching the Model with the Data
The Methodology
As shown above, the pattern of output in our simple
model depends upon the technology shocks in each of the
two periods. In a more sophisticated multi-period model,
typically used in such work, one can observe distinct
cyclical fluctuations whose general characteristics will
depend on the structure of the technology shock process,
which is the primary source of exogenous impulses. A

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model builder can then obtain a set of descriptive statistics on artificial time series generated by simulating this
model. These statistics can then be used to examine the
explanatory power of a model, not only in terms of the
qualitative implications, but also in terms of quantitative
similarity to the actual time series data.
In practice, this methodology is implemented in the
following way. First, one chooses explicit specifications for

the preferences of consumers, the aggregate production
technology, and an exogenous impulse generating mechanism. For example, the researcher may decide that the
Cobb-Douglas function is a good representation of the
production technology or that the stochastic process for
technology shocks is well described as a first order autoregression. Second, the artificial economy is calibrated,
that is to say, the researcher chooses specific parameter
values for the functional forms she has selected. For
instance, if the researcher were to employ the CRRA utility
function described above, she would have to choose values
for'Y and A. Similarly, the values for the parameters of the
production function (<Xl and <X z in our example above) also
have to be estimated. Typically, some of these values are
drawn from various micro and macro studies; for example,
the parameters measuring the degree of risk aversion, as
well as the shares of labor and capital in the aggregate
production function are obtained in this way. Values for
other parameters are obtained by imposing the condition
that the model's steady state implications are similar to
long-run observations for the U. S. economy. This includes,
for example, the average proportion of time devoted to
leisure and to work, the inter-temporal discount factor (~in
our model), etc.
Next, the model economy is solved for an equilibrium,
and decision rules for the representative individual are
obtained. These rules specify individual behavior as functions of state variables (such as the capital stock carried
over from the last period) and the exogenous shocks. For
our simple model, equation (11) presents the relevant
decision rules. The capital stock does not show up in (11)
because of our assumption of 100 percent depreciation.
Before going further, it also is worth pointing out that only
a certain limited class of specifications for preferences and
technology allow one to obtain a closed form, or an
analytical solution. Consequently, some type of approximation procedure is usually adopted in practice. 7
Armed with these decision rules, we are now ready to
face the critical test: how well does the model economy
mimic the real one? Answering this question involves
using the model economy to generate artificial data. Since
the model is driven by random shocks, this involves
repeated draws from the probability distribution specified
for the technology shock process. This artificially generated data is then compared to data for the US. economy.
Prior to making such a comparison, the data need to be
transformed to make them stationary. One way to do so is to
use the method employed by Kydland and Prescott (1982),
and to apply a filter proposed by Hodrick and Prescott
(1980) to both the actual and artificial data. The usual

practice then is to summarize the detrended data in terms
of its second moments (such as the standard deviations and
correlation coefficients), and to compare these statistics on
the artificial economy with the corresponding statistics for
the US. economy.
The Comparison
Table 1 presents one such example, reproduced from
Kydland and Prescott (1982).8 Notice that the standard
deviation of output in the model economy is exactly the
same as in the U.S. economy. This is by construction.
Specifically, as part of the calibration process, the size of
the technology shock in the model economy is chosen to
obtain this result. This does not restrict the other variables
in the model economy to behave in the same way as they do
in the US. economy, and a comparison of these variances
and covariances provides a way of judging the model's
adequacy. This is because the relative behavior of different
variables also is a function of the model's structure-its
propagation mechanism-and does not depend only upon
the kind of exogenous shock process that is employed.
Later, we will discuss how altering the nature of the
technology shock process alters the behavior of the model.
As Kydland and Prescott point out, the model captures
the relative size of the fluctuations in output, consumption,
and investment. Thus, investment is substantially more
volatile than income in both the US. and the model
economies, while consumption is less volatile. Recall that
our simple model also leads to the result that investment is
more volatile than consumption. In addition, the KydlandPrescott model also captures the strong, positive correlation between these variables and output.

Economic Review / Spring 1991

Obviously, the model does not provide a "perfect fit."
For example, both consumption and labor hours are only
half as volatile in the model economy as they are in the U. S.
economy. Of the two, attention has focused upon "fixing"
the problem with labor hours. Kydland and Prescott attempted to raise the variability of labor hours in their model
economy by increasing the substitutability of leisure in
different periods. The results of this attempt are already
incorporated in Table 1; obviously, their attempt was not
completely successful.
A number of subsequent papers also have focused on this
problem. Kydland (1984) assumes that there were two
different kinds of workers-differentiated on the basis of
work skills-and shows that this led to greater variability
in labor hours than the homogeneous labor case. Using a
suggestion by Rogerson, Hansen (1985) shows that indivisibility of labor could be the reason for the relatively high
variability of labor hours. Allowing for indivisible labor,
Hansen shows that in his model economy the standard
deviation of labor hours was roughly 80 percent of that in
the data for the U. S. economy (compared to the ratio of 50
percent shown in Table 1). Cho and Rogerson (1988) allow
for heterogenous labor (or household production) and show
that in their model economy total hours are roughly 10
percent more variable than in the U. S. economy (over the
1955-1984 period).
While these attempts have been focused on making the
model economy match the "stylized facts," other economists have directed their efforts towards a closer examination of the stylized facts themselves. Singleton (1988)
argues that since traditionally defined seasonal, cyclical,
and secular components of time series have common
determinants, prefiltering the data leads to a violation of
the restrictions imposed by the theory. Consequently, the
results are likely to be functions of the method used to
prefilter the data. Using a bivariate Vector Autoregression
of real wages and hours worked, he shows that Granger
causality tests as well as variance decompositions are
sensitive both to whether the data is seasonally adjusted
and to the treatment of the secular component. He also
points out that the filter used by Kydland and Prescott leads
to results similar to those obtained after the data is first
differenced.
King, J;>losser, and Rebelo (1988, p. 225; hereafter KPR)
also point out that the "stylized facts" about the U.S.
economy are sensitive to how the data is detrended. Since
". . . the basic neoclassical model has implications for
untransformed macroeconomic data and not some arbitrary
or prespecified transformation or component that is defined outside the context of the model," they argue that the

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procedure employed to detrend the data should be consistent with the theoretical model. KPR work with a model
in which deterministic labor-augmenting technological
change is the engine of growth, and in which technological
change itself takes place according to a log linear trend.
Consequently, they study deviations of the log levels of
output,consumption, and investment from a common
linear trend. Labor hours are not detrended since they show
no trend.
When post-war U.S. output (for the 1948-1986 sample
period) is detrended this way the standard deviation of
labor hours is only half as much as that of output, in
contrast to the nearly equal standard deviations obtained
after the Hodrick-Prescott filter is used (see Table 1). Thus,
the evidence on the relative variability of labor hours seems
sensitive to the detrending procedure employed. 9
The Role of the Technology Shock Specification
The specification of the technology shock process is
obviously a central issue. KPR examine how the behavior
of the model economy changes in response to changes in
the technology shock process. They find that if the technology shock is not serially correlated there is no serial
correlation in output, investment, or labor hours, while
consumption, wages, and the real interest rate continue to
be serially correlated. Thus, fluctuations in output appear
to reflect fluctuations in the technology shock process. In
addition, the degree of persistence of the technology shock
affects the relative volatility of different variables. For
instance, more persistent technology shocks reduce the
variability of labor hours. Highly persistent shocks imply
that the return to working in adjacent (or nearby) periods is
roughly the same, so the intertemporal substitution of labor
becomes less desirable.
Do technology shocks in fact follow the kind of process
required by RBC models to mimic key features of the U. S.
economy? The problem here is that we do not directly
observe the process governing the evolution of technology.
To get around this problem, Prescott (1986, p. 25) suggests, "One method of measuring technological change is
to follow Solow (1957) and define it as the changes in
output less the sum of the changes in labor's input times
labor share and the changes in capital input times capital
share. Measuring variables in logs, this is the percentage
change in the technology parameter of the Cobb-Douglas
production function." After examining data on the U.S.
economy for the 1955-1984 period he concludes that the
process governing the change in technology is close to a
random walk with drift, and so is consistent with the
technology shock process assumed in RBC models. 1O

Accepting the Solow residuals as an appropriate measure of technological shocks to the U. S. economy gives us
an additional dimension for judging the performance of the
RBC model. Recall that Kydland and Prescott (1982)
chose the size of the technology shock to match the
standard deviation of output. If the measured Solow residuals are used as exogenous technological shocks instead, the model's prediction of the standard deviation of
real output can be compared to that of the U. S. economy.
Kydland and Prescott (1989) do exactly that, and conclude
that about 70 percent of U. S. post-war cyclical fluctuations
are induced by variations in the Solow technology parameter. 11 A similar strategy is followed by Plosser (1989),

who inputs the measured Solow residual for the U. S.
eCOl1omy{overthe 1954-1985 period) into aRBC model. In
contrast to th~ Kydland and Prescott method of looking at
the second moments of the data, this procedure leads to
simulated time series for the major economic variables
(such as output, consumption, etc.) that can be compared
directly to data for the U. S. economy. Plosser finds that the
simulated data are close to the actual data, with the
coqelations between the two ranging from .52 to .87 for
different sel'ies. However, .these papers do not provide a
formal means ofjudging how close the predicted values are
compared to the actual values. We will return to these
issues in Section IV.

III. What Does Money 007 12
The RBC models that we have surveyed above have
shown that it is possible to have economies display business cycle-like behavior without reference to money. This
is in marked contrast to more traditional analyses, such as
Friedman and Schwartz (1982), Lucas (1975) and Barro
(1976), which assign an important role to monetary disturbances. Indeed, some have argued that this is the
distinguishing feature of RBC models (as we point out in
the introduction).
It is also possible to assert that some form of monetary
neutrality is assumed implicitly in RBC analysis. However,
to regard monetary neutrality as the only defining tenet of
RBC theories would be similar to claiming that most
papers in public finance are studies of monetary neutrality
because they fail to include money in the models. It seems
more likely that the omission of money or financial market
variables reflects the fact that early contributors were more
concerned with explaining the non-monetary characteristics of business cycles. For instance, KPR (1988, p. 196)
stress that it is necessary first to understand the effects of
real disturbances, and that, "Without an understanding of
these real fluctuations it is difficult a priori to assign an
important role to money." 13
Indeed, more recent research in this field focuses on the
issues related to monetary aspects of the aggregate economy. Since they are "fully articulated" economies, it is
necessary to motivate the use of money in these models by
explicitly specifying some kind of transactions technology.
Below, we discuss the two alternative mechanisms that
have commonly been used in these analyses: the cashin-advance constraint and the shopping-time technology
specification (or a household production technology). A
series of related questions can be asked once money is
introduced into an RBC model. How successful are these

models. in ~xplaining the observed correlations among
output, money, and other real and nominal variables? What
is the nature of the causal link between fluctuations in
money and output? Alternatively, does the inclusion of
money improve our ability to explain business cycles?
One way of introducing money in an RBC economy is to
model it as an input into the transactions technology. King
and Plosser (1984) and Kydland (1989) adopt a shoppingtime technology to model the transactions role of money.
Specifically, they assume that the time required to carry out
transactions varies inversely with the amount of money
h~ld. Huh (1990) adopts a household production technology whiC;h requires the use of both physical output and
money to gen~rate actual consumption for consumers. 14
King anq Plosser (1984) focused on explaining the
procyclical correlation between output and the broad monetary aggregates (such as MI) that has been observed in the
U.S. economy. They introduce separate competitive firms
(banks) that produce transactions services. These services
artdemande<.i by both households (because of the shopping
time t~chn?logy) and firms (as an input to the production
prOC;~ss). Thus, .banks will increase the supply of transactions s~rvices response to a favorable technology shock
to.thefinal-goo<.i-producing firms to meet the increased
de1lll}nd of bpth the firms and consumers. Consumer
demand for transactions services goes up because the
0pp9rtunity cost of leisure time, as well as the val~e of time
t~tn up.byshopping activities, has gone up due to an
increase in the real wage rate. Thus, the King-Plosser
model predicts the observed positive correlation between
output ~lllq insid~ Iiloney. However, it is important to note
that th~ causal relationship between the two is the reverse
of what is traditionally assumed-an inc;rease in output
leads to an increase in the money stock, and not vice versa.

Economic Review I Spring 1991

The price level is determined in the market for government
issued currency, which is demanded by households as a
substitute for transactions services supplied by financial
intermediaries.
The King-Plosser paper emphasized establishing a
plausible theoretical construct that gave rise to reverse
causation, and the quantitative analysis characteristic of
RBC analysis was not carried out. To carry out such an
analysis one needs to calibrate the transactions technology
explicitly based on empirical studies of individual or
household behavior with respect to money holdings and
purchasing patterns. This way of modeling provides a
practical route that can potentially capture and measure the
role of money as a medium of exchange in a real economy.
This also will impose empirical discipline on studies of the
monetary aspect of an economy, similar to that found in
other RBC analyses. IS
Kydland (1989) examines the implications of allowing
the possibility of a tradeoff between leisure and money as
envisioned in a shopping time technology. One interesting
finding is that the price level of the model economy turns
out to be half as variable as the CPI of the U. S. economy,
even with a constant money stock assumption. These price
level fluctuations in the model economy are due to shifts in
the demand for real balances which, in turn, vary entirely
due to the desire of agents in the economy to substitute
leisure (or labor) over time. The price level also exhibits a
negative contemporaneous correlation with output in this
economy, a feature that both Cooley and Hansen (1989) and
Kydland and Prescott (1990) also find in post-war U.S.
data. However, Kydland finds that introducing money in
this way does not change the behavior of either output or
labor supply in the model economy.
Huh (1990) obtains a more comprehensive accounting of
the pattern of comovements among output, money stock,
and price level observed in the U. S. time series data. Huh
adopts a household production specification of demand for
money, which requires the use of both physical output and
money as input factors in generating actual consumption.
The money supply of the model economy each period is
determined by an explicit monetary reaction function,
which depends upon both lagged real shocks and past
values of money growth. Given this specification, the
model economy exhibits a spurious positive comovement
between money and output that approximates the positive
correlation observed in U. S. time series data on the two
variables. Variations in the steady state rate of inflation
turn out to have real effects in this economy.l6 However,
changes in the money supply do not seem to be an important source of business cycle movements.

Federal Reserve Bank of San Francisco

Huh partially exploits the added opportunity of imposingempirical discipline that was discussed earlier. For
example, the paper uses information about the relative
variability of a·broader measure of monetary aggregates
(Ml) over a narrowly measured one (monetary base) in
calibrating the money supply function. Butno comparable
procedure was implemented with regard to the transaction
technology calibration.
The other specification that has been employed in these
models is thecash-in-advance (or liquidity) constraint,
wnich motivates the introduction of money by simply
requiring the use of money in making transactions. Various
economic implications of the cash-in-advance constraint
have been extensively studied in monetary economics (for
example, see Lucas (1980), Lucas and Stokey (1987),
Stockman (1981». Cooley and Hansen (1989) apply this
liquidity constraint to the RBC economy of Hansen (1985).
In the Cooley-Hansen economy, goods can be divided
into two groups: cash goods and noncash goods, depending
on whether the purchase of a good requires the use of cash
(e.g., consumption) or not (e.g., leisure). Money is nonneutral because anticipated changes in money affect the
relative price of consumption (cash good) and leisure
(noncash good). Cooley and Hansen found the steady state
welfare cost of inflation to be nontrivial in their economy.
However, variations in the money supply do not have much
impact on the cyclical behavior of the real variables in their
model either. I? The authors speculate that money may have
a largerrole to play in a model with restrictions on available
information similar to those in Lucas (1972).18
Kydland (1989) carries out such an exercise. To measure
the· informational impact in isolation, Kydland adopts a
version of the model economy of Lucas (1972) which is
populated by spatially separated agents. The information
structure assumed by Kydland implies that agents must
extract information about the real wage from observations
on tne nominal wage. Monetary shocks alter the price level,
thereby complicating the agent's signal extraction problem. However, it turns out that variations in the growth rate
of money do not lead to significant cyclical movements in
this model either. 19
Overall, these (ongoing) efforts to extend standard RBC
research to allow a role for money have produced interesting results. These studies provide a positive answer to the
question of whether there exist plausible specifications that
can explain (in the sense of Lucas (1977» a set of key
observations on nominal quantities and prices. However,
theans\Ver to the question of whether these specifications
of money are an exhaustive and sufficiently robust mapping ohhe role of money in the "real" economy seems less

clear. Thus far, for example, no studies based on the RBC
premises have shed light on the effects of open market
operations involving different types of instruments of
government indebtedness. 2o Another potential source of

nonneutral money is some form of a nominal contractual
arrangement. 21 Consequently, it seems inappropriate to
interpret the results of these studies as demonstrating that
money has no role to play in causing business cycles.

IV. What the Critics Say
The developments in RBC theory surveyed above represent innovations both in terms of technique and in ways of
thinking about business cycles. However, that does not
imply that RBC theory is free from shortcomings. In this
section we review some of the criticisms leveled against
this approach. We begin by reviewing what critics have to
say in three broad areas. First, economists have expressed
concern about a key propagation mechanism in these
models, namely, the intertemporal substitution of leisure.
Second, they have criticized the theory's reliance upon
technology shocks. And third, they have also questioned
the method by which parameter estimates have been obtained, that is to say, they have questioned the technique of
"calibration." We conclude the section by summarizing
some additional criticisms of the theory.
As discussed above, this approach relies upon intertemporal substitution of leisure to generate business cycles.
This reliance has been criticized on several grounds. For
instance, Walsh (1986) points out that while labor supply is
procyclical, most of the cyclical variation in employment
is accounted for by changes in the employment rate, rather
than by changes in the labor force as the theory would
predict. Since recessions are periods of low return, the
theory also predicts that the quit rate should be countercyclical, whereas the data show that the quit rate is
procyclical.
In addition to concerns about the mechanism generating
business cycles, questions have also been raised about the
nature and role of the technology shocks. For instance,
Summers (1986) wonders where the technology shocks are,
and whether recessions should be defined as periods of
technl[)loglcal regress. A similar sentiment is expressed by
Mankiw (1989, p. 85): "The existence oflarge fluctuations
in the available technology is a crucial but unjustified
assumption of real business cycle theory."
Over the postwar period, probably the most prominent
aggregate shocks have been the changes in the relative
price of oil. Since oil is a major input, variations in its
relative price are likely to have a measurable impact on
economy-wide output. However, in a recent study, Kim and
Loungani (unpublished, p. 18) find that" ... the inclusion
of energy price shocks leads to only a modest reduction

in. the RBC model's reliance on unobserved technology
shocks."
It is also possible that the economy-wide technology
shocks represent the aggregation of a large number of
shocks to different industries. However, this notion is
questioned by McCallum (1989, p. 29), who states that if
th~ term. technology shock is ". . . . taken literally to refer
to shifts in the state-of-knowledge technological relationship betweeninputs and outputs, then it would seem highly
unlik~ly that there could exist any substantial aggregate
variability." This is because the economy contains a large
number of different sectors employing different technologies, and shocks to these technologies should be more or
less independent. Since the economy-wide technology
shock would be an average of these industry-specific
shocks, it would evolve more smoothly than what RBC
models seem to require.
Prescott's use of the Solow residual to measure the size
of the technology shock has also been criticized. Recall
that the Solow residual is obtained as a residual from a
(Cobb-Douglas) production function using labor and capital as inputs. This proGedure implies that errors in the
measurement of labor and capital will show up as variations ill the ~stimated Solow residual (since the errors in
measuring output are likely to be uncorrelated with the
errors in measuring labor and capital). Consider, for example, what happens when there are variations in the rate of
capital utilization. Since the measured Solow residual is
based upon an assumption of 100 percent capacity utilization, any change in the rate of capacity utilization will be
measured as a technology shock. 22
Variations in "the rate of utilization" for the labor input
are likely to have similar effects. Eichenbaum (1990)
points out that allowing for labor hoarding in an RBC
model drastically reduces the role of technology shocks.
Thus, naive Solow residual accounting overestimates the
variance of the technology shocks.
McCallum (1989) also points out that the Solow residual
will overestimate the variance of the technology shock in
the presence of adjustment costs. (Adjustment costs can be
one reason for labor hoarding.) As evidence, he points to a
study by Jorgenson and Griliches in which the elimination

Economic Review / Spring 1991

of aggregation errors and a correction for variations in
lahor and capital utilization reduces the role played by the
Solow residual (in explaining output growth) to only 7
percent of the initial estimate.
A number of others have also expressed similar reservations about the use of the Solow residual to measure
technology shocks. According to Hall (1989), the Solow
residual is correlated with oil prices, military spending,
and even the political party of the president. Similarly,
Evans (1990) shows that the Solow residual is correlated
with alternative measures of the money supply. These
correlations contradict the assumption that the Solow residual only measures shifts in the production function.
If the Solow residual is not a good measure of technology shocks, what are we left with? RBC proponents have
not done a good job of coming up with alternatives, leaving
critics to wonder how the theory can be verified.
The next major criticism of RBC models has to do with
the issue of statistical inference. The basic problem is that
the calibration techniques discussed above do not take
account of the uncertainty that exists regarding the true
value of the parameters. Thus, Manuelli and Sargent
(1988, p. 531) express concern about the use of out-ofsample evidence to estimate parameters since it precludes
the use of a formal probability model to make judgments
about the results. They further ask "Does it matter how the
extraneous (out of sample) parameter estimates have been
made? Were these estimates obtained using a theoretical
structure consistent with the general equilibrium structure
Kydland-Prescott maintain? Were the extraneous estimates obtained in ways that would be statistically consistent in view of the cross-equation and cross-frequency
restrictions imposed by the Kydland and Prescott model?"

In a similar vein, Eichenbaum (1990, p. 9) states
". . . calibration exercises do not provide any information
on howloudly the data speak on any given question." He
takes issue with Kydland and Prescott's contention that
technology shocks account for 70 percent of the business
cycle variation in post-war U.S. output. On the basis of his
attempt to incorporate parameter uncertainty into measurements of the role of technology shocks, he concludes
that". . . we ought to be very comfortable believing that
the model explains anywhere between 5% and 200% of the
variance in per capita U.S. output." In other words, the
role of technology shocks is very imprecisely estimated.
A number of other criticisms have also been made. For
example, some economists (Summers (1986), among others) find a pervasive use of the "representative agent"
construct in RBC theories objectionable. In addition, the
model has only been tested on postwar U. S. data so far.
Critics have pointed out the need to test the model using
alternative samples. Rogoff (1986), for example, has suggested estimating the model for different countries.
Ingram and Leeper (1990) argue that the use of RBC
models to examine policy issues may be subject to a
version of the Lucas critique. 23 This criticism is applicable
to models that use parameter values used in calibrating
early RBC models which ignored the effects of policy
(e.g., Kydland and Prescott 1982). Ingram and Leeper
show that ignoring the effects of monetary policy in a world
in which policy has real effects implies that some of the
estimated parameters will be reduced form coefficients.
Policy analyses based on the assumption that these are
deep, policy invariant parameters will, therefore, lead to
incorrect inferences.

V. An Appraisal
Clearly, RBC models are not without their critics.
Nevertheless, this line of inquiry has made important
contributions to economic analysis. RBC models represent
a significant innovation in economic modeling, since they
were the first operational models based upon microeconomic foundations. As such, they provide a coherent,
logically consistent way of thinking about the macroeconomy. At one level, these models provide a useful counterpoint to the view that in the absence of fiscal and monetary
policy shocks, real output would grow at a steady 3 percent
annual rate (or whatever the sample average growth rate
would happen to be).
One· attraction of these models is that they provide a
relatively straightforward way of testing theories against

FederalReserve Bank of San Francisco

data. However, existing RBC models are highly stylized
and do not have the same econometric detail as the large
scale Keynesian models often used for policy purposes.
So what can these models tell us about how to conduct
policy? Kydland and Prescott suggest that we need to learn
more about business cycles before making policy recommendations. For instance, in Kydland and Prescott (1988,
p. 358) they state, "Our analysis should not be interpreted
to mean that fluctuations are optimal and that there is no
role for stabilization policy. Our view is that public finance
considerations are not the principal factor driving the
business cycle and that abstracting from them at this stage
is warranted. Only when we have considerable confidence
in a theory of business fluctuations would the application

of public finance theory to the question of stabilization be
warranted."
Their conclusion is based on a model that does not
explicitly incorporate either public spending or money.
What can we say on the basis of models that do? As
discussed above, changing either the growth rate of money
or the size of the monetary shocks in these models does not
have a significant effect on the cyclical behavior of the real

variables. On the surface, this seems to suggest that monetary policy is not very important. However, existing models
are not yet rich enough to support such a conclusion. For
instance, these models allow only a limited role for money
and do not allow for .other nominal assets. Thus, the
available evidence does not seem sufficient (or· robust
enough) to convince a risk-averse policymaker either to
adopt or to abandon a specific course of action.

Economic Review I Spring 1991

NOTES
1. Their first paper on this topic ("A Competitive Theory of
Fluctuations.. . ") was published in 1980, though Kydland and Prescott (1982) is more frequently cited.
2. This function belongs tothe constant relative risk aversion (CRRA) class. See Blanchard and Fischer (1989) for a
discussion.
3. A simpler production function does impose costs. For
instance, our specification implies a constant marginal
product of labor and consequently a constant wage rate.
4. For our purposes the important point isthat the z;'s shift
the marginal product of capital.
5. In our specification, Y1 is not equal to Y2 even in the
absence of shocks. However, this difference is not central
to our discussion, since our focus is on the change in
output in response to the technology shocks.
6. The elasticity of intertemporal substitution is a fundamental determinant of the volatility of consumption. For
example, if the utility function is linear in consumption, the
elasticity of the intertemporal substitution of consumption
becomes infinitely large. Since individuals do not care
about the period they consume in, consumption becomes
extremely volatile. To demonstrate this heuristically, suppose that the two-period utility function is as follows:
-1

U(C1, C2) =

[q-P + C2 P] P ,

where Ci denotes consumption in period i for i = 1, 2. The
elasticity of substitution between c 1 and C2 is given by
1/(1 + p), The utility function becomes linear when p is -1.
Note that the elasticity of substitution goes to infinity as p
approaches -1.
7. See Kydland and Prescott(1982), and King, Plosser
and Rebelo (1988) for two distinct solution procedures. A
comparison of alternative solution procedures is contained in the Journal of Business and Economic Statistics,
January 1990.
8. King and Plosser (1989) employ a different technique
to carry out tests of RBC models.
9. KPR also cite other work by King and Rebelo that
demonstrates that applying a low frequency filter (such as
first differences) to the data from a theoretical economy
raises the correlation between output and labor input.
10. Also see Kydland and Prescott (1988).
11. Their model is more general than the one discussed
above, since it allows labor input to change both in terms
of hours per worker and the number of employed workers.
12. As mentioned above, there are many extensions of the
basic Kydland-Prescott model that we do not cover in our
survey. For instance, Stockman (1988, 1990) deals with
open economy issues. Christiano and Eichenbaum (1988)
examine the effects of shocks to government spending in
an RBC model. Christiano (1988) introduces inventories.
13. A somewhat different view is expressed by Eichenbaum and Singleton (1986, p. 92):
"In our view, proponents of real business cycle theories

Federal Reserve Bank of San Francisco

are not claiming that monetary policy cannot or has never
had.a significant impact on the fluctuation of real output,
investment, or consumption. Rather we subscribe to the
second interpretation of RBCanalyses as investigations of
real. allocations under the assumption·· that, toagood
approximation, monetary policy shocks have played an
insignificant role in determining the behavior of real
variables. "
14. These techniques of introducing money are closely
rel.ated to the money-in-utility-function (MIUF) approach.
The MIUF approach is criticized by some monetary theorists as implicit theorizing because of its reliance on the
underlying model and its assumptions with implications
that might be contradictory to those of the final model (for
a critical discussion, see Kareken and Wallace (1980)).
15. However, there is a justifiable concern about implementing this technique for a monetary economy. According to this methodology, one has to get estimates of
the deep parameters governing preferences and technology that are invariant with respect to any type of monetary
policy shifts and interventions. It might be especially
difficult to obtain or isolate such information about the
parameter values of the underlying transaction technology from data.
16. In both the Huh economy and the Cooley-Hansen
economy (discussed below) changes in the steady state
inflation rate have effects that are the opposite of the
"Tobin effect." The Tobin effect implies a positive correlation between the steady state inflation rate and the capital
stock. It arises as a result of portfolio substitution: an
increase in the rate of inflation, for instance, lowers the rate
of return on money and causes individuals to substitute
into physical capital. By contrast, in a cash-in-advance
model, an increase in inflation makes activities that
require the use of money (purchases of consumption
goods) less attractive relative to other activities (leisure),
because of the decrease in the purchasing power of
money holdings due to inflation. For more discussion see
Stockman (1981) and Lucas (1987).
17. It is important to realize that a cash-in-advance constraint imposes some significant restrictions on the model
structure. The first is the exogeneity of the length of the
period defined in the economy, which was first pointed out
by Harris (1980). Cash balance holding in a cash-inadvance economy is analogous to a hot potato, where the
temperature of the potato measures the rate of inflation in
the economy. The higher the inflation (Le., the hotter the
potato), the faster one wants to dispose of it. In this
economy, the length of each period is defined as the time
for which money is held, and, therefore, the velocity of
money is defined to be one. Consequently, the length of
the time period might change as the purchasing power of
cash holdings varies due to changes in monetary policy,
that is, as the economy moves between high and low
inflation.
The next restriction is not unrelated to the first. The
exogenous grouping of goods in terms of cash versus

noncash goods is too restrictive, As the prevailing inflation
rate changes, the scope of transactions involving cash
versus noncash (credit or barter) is very likely to shift.
18, These restrictions lead to confusion about aggregate
and relative price changes, and therefore cause money to
have real effects,
19, Monetary misperception has been regarded as a
potentially important source of monetary non-neutrality
not only by the economists in the Lucas-Barro tradition,
but also by some current practitioners of RBC theories
(see the earlier discussion of the Cooley-Hansen paper),
Thus, the test by Kydland has added significance, However, in an attempt to isolate the effect of money through
informational confusion, a stringent neutrality is imposed
onthe model economy, In the model economy, individuals
are paid in fiat currency (nominal wage), but it is unclear
how transactions of goods are consummated or what

happens to the individual money holdings in his "islands"
economy, Consequently, interpreting the noise component of the observed nominal wage as a money or aggregate price shock seems arbitrary,
20, Imrohoroglu and Prescott (1990) is intended to examine some of these issues,
21. For example, Stadler (1990) obtains a strong nonneutrality result by incorporating a temporarily fixed nominal wage contract feature in an otherwise real model. We
regard the assumed fixity too extreme and implausible,
but it is one demonstration that such complications may
alter the usual "effectively neutral money" results,
22, Greenwood, Hercowitz, and Huffman (1988) analyze
an· RBC model in which the rate of capital utilization is
endogenous,
23, See Lucas (1976).

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____-, and Nancy Stokey. 1987. "Money and Interest
iniaGash-in-Advance Economy." Econometrica 55,
pp. 491-514.
Mankiw, N. Gregory. 1989. "Real Business Cycles: A New
Keynesian Perspective." Journal of Economic Perspectives (Summer) pp. 79-90.
Manuelli, Rodolfo, and Thomas J. Sargent. 1988. "Models
of Business Cycles: A Review Essay." Journal of
Monetary Economics 22, pp. 523-542.
McCallum, Bennett T. 1989. "Real Business Cycles." In
Modern Business Cycle Theory, ed. R.J. Barro. Cambridge: Harvard University Press.
Plosser,.Charles I. 1989. "Understanding Real Business Cycles." Journal of Economic Perspectives 3,
pp.51-79.
Prescott, Edward C. 1986. "Theory Ahead of Business
Cycle Measurement." Carnegie Rochester Conference Series, Vol. 25, pp. 11-44.
Rogerson, Richard D. 1988, "Indivisible Labor, Lotteries
and Equilibrium." Journal of Monetary Economics 21,
pp.3-16.
Rogoff Kenneth. 1986. "Theory Ahead of Business
Cy~le Measurement: A Comment on Prescott." Carnegie Rochester Conference Series, Vol. 25, 1986,
pp.45-47,
Singleton, Kenneth J. 1988. "Econometric Issues in
the Analysis of Equilibrium Business Cycle Models."
Journal of Monetary Economics 21, pp. 361-386.
Solow, Robert M. 1956. "A Contribution to the Theory of
Economic Growth." Quarterly Journal of Economics
70, pp. 65-94.
Stadler, George W. 1990. "Business Cycle Models with
Endogenous Technology." American Economic Review 80, pp. 763-778.
Stockman, Alan C. 1981. "Anticipated Inflation and the
Capital Stock in a Cash-in-Advance Economy." Journal of Monetary Economics 8, pp. 387-393.
_ _ _ _ .1988. "Real Business Cycle Theory: A Guide,
an Evaluation and New Directions." Federal Reserve
Bank of Cleveland Economic Review (Quarter 4)
pp.24-47,
- - - - . 1990. "International Transmission and Real
Business Cycle Models." American Economic Review, Papers and Proceedings (May) pp. 134-138.
Summers, Lawrence. 1986, "Some Skeptical Observations on Real Business Cycle Theory." Federal Reserve Bank of Minneapolis Quarterly Review (Fall)
pp.23-27.
Walsh Carl E. 1986. "New Views of the Business Cycle:
H~s the Past Emphasis on Money Been Misplaced?"
Federal Reserve Bank of Philadelphia Business Review (Jan/Feb) pp. 3-14,

Japanese Capital Flows in the 1980s

Reuven Glick
Research Officer, Federal Reserve Bank of San Francisco. Editorial Committee members were Sun Bae Kim,
Jonathan Neuberger, and Gary Zimmerman. Research
assistance by Mary-Linda Chan is gratefully acknowledged.

Concern about the extent to which Japanese investors
will continue to invest abroad has prompted attention
to understanding the determinants of Japanese capital
outflows. This paper discusses Japanese capital outflow
trends and their determinants during the 1980s. It highlights the roles of excess Japanese savings, U.S. government budget developments, and Japanese financial market
liberalization. It concludes that the massive Japanese
capital outflows during most of the 1980s are likely to
decline in the future.

During the 1980s Japan became the world's largest
capital exporter. From a mere $10 billion in 1981, its net
long-term capital outflows rose to a peak of $137 billion in
1987, before declining to the still substantial level of $89
billion in 1989. As the world's largest capital exporter,
Japanese investors have been leading acquirers of U.S.
securities and other types of debt, with net long-term
capital outflows to the U. S. amounting to $54 billion
in 1989.
Many policymakers, especially in the United States,
have been concerned about the extent to which Japanese
investors will continue to invest abroad, in general, and in
dollar assets, in particular. If Japanese portfolios become
too saturated with holdings of dollar assets, it is argued,
Japanese investors will curtail their demand for U. S. assets
and/or require larger risk premiums for continuing to hold
these assets. Such behavior would adversely affect U.S.
financial markets by inducing higher U. S. interest rates
and a lower value of the dollar.
Understanding past and current determinants of Japanese capital outflows is important for evaluating the
prospects for future outflows. The logic of macroeconomic
accounting implies that Japan's capital outflows are the
counterpart of its current account surpluses during the past
decade. A country's current account is, in essence, the
macroeconomic balance between national savings and
investment. To the extent that a country runs a current
account surplus by exporting (selling) more goods and
services than it imports (buys), it must lend the difference
to foreigners. It does so by investing and acquiring an equal
amount of net claims on foreigners through its capital
account. Correspondingly, a country that imports (buys)
more than it exports (sells) must borrow the difference by
issuing liabilities to foreigners. Thus U. S. capital inflows
are the counterpart of U.S. current account deficits.
Most discussion of Japan's capacity and willingness to
finance U.S. current account deficits has focused on trade
in goods and services and factors that influence Japanese
net exports and U.S. net imports of goods and services,
such as relative price levels and income levels'! The logic
of macroeconomic accounting, however, implies that capital flows are also important. It suggests that relative
savings and investment levels and interest rates, factors
Economic Review / Spring 1991

that more directly influence Japanese net demand for
foreign assets, are important as well.
From this perspective, the accumulation of U.S. assets
by Japanese investors need not be viewed as purely residual and involuntary behavior necessary to finance the
ongoing excesses of U. S. imports of goods and services
over exports. Rather the increase in capital outflows from
Japan may at least in part have arisen for other independent
reasons.
This article discusses recent trends and features of
Japan's net capital outflows during the 1980s and the major
factors that brought about their increase. It highlights the
roles of both macroeconomic and microeconomic factors,
particularly those independent factors that have directly
influenced Japan's capital account transactions.
On the macro level, underlying the rapid Japanese

accumulation of overseas assets during the 1980s has been
the emergence of a large excess of domestic saving over
domestic investment in Japan. Rising budget deficits and a
corresponding demand for capital in the United States have
played an important role as well. On the microeconomic
level, the process of financial market liberalization in Japan
permitted greater competition among individual financial
institutions and allowed more Japanese investors to engage
in international capital transactions.
The paper is organized as follows. Section I looks at the
trend and composition of Japanese international capital
account transactions. Section II discusses the role of macroeconomic factors for the rise in net Japanese outflows.
Section III examines the role of microeconomic and institutional factors. Section IV discusses the outlook for the
magnitude of future Japanese capital outflows.

I. Japanese International Transaction Trends
Current and Capital Account Overview
Table 1 presents figures for broad categories of Japan's
international transaction flows for the period 1980-90. 2 As
the figures indicate, Japan has experienced sustained current account surpluses since 1981. These surpluses have
increased rapidly, rising from $5 billion in 1981 to a peak of
$87 billion in 1987, roughly 4 percent of Japan's GNP.
Since then the current account surpluses have declined.
The rapid rise in Japan's current account surplus since
1981 has had its counterpart in a greatly increased net
outflow of capital, particularly in net long-term investments.3 (Net long-term investments are defined as gross
outflows of capital invested in foreign assets minus gross

inflows of capital invested in Japanese liabilities, all with
maturities of more than one year.) Net long-term capital
account outflows rose from $10 billion in 1981 to $137
4
billion in 1987, before falling to $89 billion in 1989. The
partial data available for 1990 indicate that this decline in
5
capital outflows is continuing.
As shown in Chart 1, since 1981, Japanese net long-term
investments have been consistently greater than the current
account surpluses. Beginning in 1986, the magnitude by
which long-term investment outflows exceeded the current
account surpluses has been particularly large. This suggests that Japanese capital outflows reflect factors motivating a greater demand for foreign assets, in contrast to the

Chart 1
Japanese Net International Transactions
BiI.US$

(annual rates)

240
200
160

120
80

Long-term Capital

40
0~~~~~~~~~~'-1F~~\.
-40

-80
Short-term capital
(Including bank flows)
·120
·160 -t-r-.,...,...r'"""".....,-..................,...,...r'"""".....,-.........................r'"""".....,-..................,...,...r'""""........
80 81 82 83 84 85 86 87 88 89 90
Note: Positive values indicate current account surplus or net capital outflows.

Federal Reserve Bank of San Francisco

Chart 2
Net Long-term Capital Outflows
(annual rates)

BII. US$

240
200
160
120

Securities

O~~~~~~

-40
-80

-120
-160

-1-0...........,...............1"""'"""".....,...............,......,..,....,..............,.............-1"""'"""".....,...........................,.......,.....,...,

Note: 'Other' includes trade credit and loans.

view that Japanese investors have acquired foreign assets
involuntarily merely to finance unbalanced trade in goods
and services.
The net long-term capital outflows arising from the
purchase of foreign securities by Japanese investors have
generally been accompanied by net short-term capital
inflows. (See Table 1.) Between 1986 and 1988 the shortterm capital inflows were especially high. These capital
inflows have been particularly associated with short-term
foreign borrowing by Japanese banks.
Net movements in Japan's official reserve assets have
reflected the foreign exchange intervention policies of
Japanese monetary authorities. Prior to 1985 these movements were negligible. Between 1985 and 1988 Japanese
monetary authorities generally accumulated foreign ex-

change reserves, particularly in 1987 ($39.2 billion) as a
result of efforts to slow the appreciation of the yen. Thus in
these years monetary authorities, in addition to private
investors, helped finance Japan's current account surpluses. In 1989 this pattern reversed. Net reserve outflows
amounting to $12.8 billion accompanied efforts to dampen
the weakening of the value of the yen. Reserve outflows
continued in 1990.
Composition of Long-Term Capital Flows
The changes in Japan's net long-term capital outflows
during the 1980s primarily reflect movements in net securities outflows. (See Chart 2.) Japan's net direct investment outflows have increased steadily in recent years, but

Economic Review / Spring 1991

fluctuated more significantly, primarily in association with
movements in Japan's stock market, and rose dramatically
to $89 billion in 1989. 8

still account for only about 20 percent of total net long-term
capital outflows. 6
On the outflow side, gross long-term foreign securities
purchases rose from $3.8 billion in 1980 to $102.0 billion
in 1986, fell off somewhat in 1987 and 1988, before rising
again in 1989 to $113.3 billion. (See Chart 3.) Foreign
securities investment averaged 72 percent of long-term
capital outflows in 1986 and 1987, but fell to 59 percent in
1988 and 1989. Roughly 80 to 90 percent of Japanese gross
foreign securities purchases have been in bonds, but a trend
towards more stock purchases has recently emerged. 7
On the inflow side, purchases of Japanese securities have
generally accounted for more than 90 percent of gross
long-term capital inflows. (See Chart 4.) These securities
inflows remained relatively constant from 1980 to 1985,
averaging $13 billion per year. Since 1986 they have

Institutional Investors
As Table 2 indicates, most of Japan's foreign securities
outflows are attributable to Japanese bank and nonbank
financial institutions. Their purchases of foreign securities
typically account for 60 to 70 percent of gross Japanese
long-term securities purchases. The remainder is attributable to nonfinancial firms and individuals, for which detailed data are not available, and is calculated as a residual.
Chart 5 presents the ratios of foreign securities holdings
to total assets for different types of financial institutions.
With the major exception of securities investment trusts,

Chart 3
Gross Long-term Capital Outflows
(annual rates)

BiI.US$

320
280
240
200
160
120
80

Secu~ities

Other
\

4~ 1-~~~~~~~~:::::::::~~
·40
·80 -;-..........,........,...,....,r-r-o......,..............-r-.........,..............,........,...,....,,........,.....-r.............,...,........,...,................,
80

Note: 'Other' includes trade credit and loans.

Chart 4
Gross Long-term Capital Inflows
(annual rates)

Bil. US$

320
280
240
200
160
120
80
40

Total Inflow

Securities \

O~:::::::::::::::~:L.:~~~:::::...+N"-J.,:=:::.~~-

·40
·80 -t-r..........,..,....,........,....,...-r-r,....,....,.,........,...,...rr""....,..,............,............,..,..,.......,,........,..........,...,...,
80

Note: 'Other' includes trade credit and loans.

Federal Reserve Bank of San Francisco

this ratio generally increased for all types of institutions
throughout the past decade. This suggests that factors
affecting the foreign investment behavior of Japanese
financial institutions have been important determinants of
Japanese outflows during the 1980s.
Despite the common trend of increase in the ratio of
foreign securities to total assets, there are differences in the
magnitude of the ratio of foreign securities to total assets
among investors. In particular, as may be observed from
Chart 5, the ratio is high for insurance firms, trust accounts, and investment trusts. The ratio for Japanese banks
is relatively low. This suggests that factors affecting the
allocation of funds among Japanese investors and their
ability to invest abroad has played a role in the composition
of Japanese capital outflows.

Geographic Composition of Securities Outflows
Where have Japanese investments been going? There are
no comprehensive direct statistics on the currency composition of Japanese foreign securities investments, but
indirect evidence is available.
Table 3 breaks down Japanese foreign securities investments, including both stocks and bonds, by the country in

which they are acquired. 9 As the table indicates, although
the United States continues to attract a high percentage of
Japanese investment, the ratio peaked in 1985 at 56 percent
and has since been declining, with a discernible sharp drop
in 1989. 10
However, a sizable proportion of overseas investments is
in Luxembourg and the U.K., centers of Eurobond trading,
particularly in Eurodollar securities. In fact, almost all of
the investment in Luxembourg is in dollar-denominated
Eurobonds. The total share of securities in the U.S.and
Luxembourg, a rough proxy for dollar-denominated investments, peaked at 78 percent in 1985, but has slowly
declined to 66 percent in 1989. II
Available data on the currency composition of foreign
securities investments by institutional investors supports
the general inference from the aggregate data that dollardenominated assets dominate overseas Japanese investments. Deguchi (1987), for example, reports data on the
composition of foreign investment by Japanese life insurance companies. He finds that at the end of 1986 these
firms held 57 percent of their foreign investment in dollardenominated securities.
The discussion in this section has identified several

Economic Review / Spring 1991

Percent

Chart 5
Foreign Seeurities as a Percent ©f
Total A sse ts by Institution

Table 3
Geographical Distribution of Japanese Securities Capital Outflows
(Billions of dollars, percent in parentheses)
1981

1982

1983

1984

1985

1986

1987

1988

1989

u .s.

1.5
(25.5)

0.4
(6.8)

5.0
(38.3)

11.4
(42.4)

31.3
(56.4)

49.6
(49.1)

37.4
(41.3)

36.2
(40.7)

26.5
(23.3)

Luxembourg

1.4
(23.4)

1.7
(26.6)

3.2
(24.4)

6.2
(23.3)

11.7
(21.1)

24.3
(24.1)

27.2
(30.0)

25.4
(28.6)

48.1
(42.3)

U.K.

1.4
(22.6)

2.0
(32.8)

2.2
(17.0)

3.8
(14.1)

6.2
(11.2)

12.8
(12.7)

8.7
(9.6)

10.7
(12.0)

11.1
(9.8)

West Germany

0.6
(9.7)

-0.1
(-1.5)

0.2
(1.3)

-0 .0
(-0 .1 )

0.4
(0.8)

3.2
(3.2)

5.6
(6.2)

6.0
(6.8)

4.5
(4.0)

Netherlands

0.2
(2.7)

-0.1
(-1.7)

0.0
(0.4)

0.0
(0.2)

-0.1
(-0 .1 )

0.1
(0.1)

0.5
(0.6)

0.8
(0.9)

0.3
(0.2)

-0 .0
(-0.1)

0.1
(1.4)

0.1
(0.5)

0.0
(0.1)

0.4
(0.4)

1.0
(1.2)

0.6
(0.6)

3.9
(3.4)

Switzerland

0.0
(0.5)

0.0
(0.7)

0.2
(1.4)

0.9
(3.5)

0.5
(1.0)

0.1
(0.1)

0.4
(0.4)

0.9
(1.0)

1.2
(1.1)

Australia

0.1
(1.9)

1.8
(28.4)

0.7
(5.5)

1.6
(5.9)

1.0
(1.7)

-0 .3
(-0 .3 )

2.4
(2.7)

1.8
(2.0)

1.5
(1.4)

Canada

0.8
(12.4)

0.1
(1.5)

1.1
(8.0)

2.1
(7.7)

2.2
(4.1)

6.6
(6.6)

2.5
(2.8)

1.4
(1.5)

4.8
(4.2)

Others

0.1
(1.5)

0.3
(4.9)

0.4
(3.2)

0.8
(3.1)

2.1
(3.8)

4.2
(4.2)

4.8
(5.3)

5.1
(5.8)

11.8

6.1
(100.0)

6.2
(100.0)

13.2
(100.0)

26.8
(100.0)

55.4
(100.0)

101.0
(100.0)

90.6
(100.0)

88.9
(100.0)

113.7
(100.0)

France

Total

Note: Excludes yen-denominated foreign bonds; includes foreign exchange-denominated bonds issued in Tokyo. Negative entries indicate
sales exceed purchases.
Source: Ministry of Finance, International Finance Bureau Yearbook, (Kokusai Kin’yu Kyoku Nenpo).

F ederal Reserve B ank o f San Francisco

major features ofJapanese capital outflows. First, net longterm outflows have exceeded current account surpluses,
particularly since 1986. Most of these outflows are associated with foreign securities purchases. Second, net shortterm capital inflows have been significant, especially those

associated with Japanese banks. Third, most Japanese
institutional investors have significantly raised the ratio of
their foreign securities to asset holdings. Lastly, most of
these capital flows have been into dollar-denominated
assets.

II. Macroeconomic Determinants of Capital Outflows
The growth and composition of Japanese capital flows
during the 1980s may be explained by a number of factors.
The macroeconomic factors, discussed in this section,
include the emergence of excess domestic savings in Japan
and growing U.S. government budget deficits, as wen as
changing exchange rate expectations and risk perceptions.
The microeconomic factors, which include the effects of
Japanese financial liberalization, are discussed in the following section.

Excess Japanese Savings
From national income account relationships, a country's
net capital outflows equal its excess domestic savings. To
the extent that a country saves more than it invests domestically, it must lend the difference to foreigners. It does so
by exporting (selling) more goods and services than it
imports (buys), running a current account surplus, and
correspondingly investing and acquiring an equal amount
of claims on foreigners through its capital account.
The domestic savings balance can be broken into a
private saving balance and a government saving balance.
Thus net capital outflows, and correspondingly the current

account surplus can be expressed as the sum of the excess
of private savings over private investment and of government tax receipts over government expenditures.
Chart 6 shows the patterns of private saving net of
investment and government saving in Japan. Between 1980
and 1986, Japan's surplus of private saving overinvestment
averaged nearly 7 percent of GNP. Although Japan's private savings rate has remained relatively high, compared to
other industrial countries during this period the .private
savings rate actually fell.l 2 However, declining domestic
investment generally offset the drop, leaving private saving
net of investment relatively unchanged.
The decline in investment through the mid-1980s can be
attributed to the reduced domestic prospects for investment
arising from a deceleration in Japan's long-run growth rate
that began in the 1950s, and continued through the 1960s
and 1970s. Kasman (1987), for example, estimates that
Japan's potential real growth fell from 9 percent over the
period 1967-1973 to 4.5 percent over 1976-1986. Other
reasons that may have contributed to the drop in investment
include higher real interest rates, diminishing returns to
investment, and the rising price of urban land which
caused residential construction to fall.

Chart 6
Japanese Excess Saving

Percent
of GNP

10
8
6
Private Saving Net of Investment

0-+--------------------7"!-::-2
-4

Government Saving

-6
-8

-1 0 -/-.,.....,-.....-,-....-r--r-r-.--,.---.-,--.-,.......-,--.-,......,-,--.-,-....---.--,
76

Economic Review / Spring 1991

The reasons for the decline in savings also included
slower growth as well as the ongoing aging of Japan's
population. Japan's birth rate has fallen significantly in
recent years. In 1989, Japan's fertility rate fell to a post-war
low; the average Japanese woman of child-bearing age had
1.57 children, down from 1.77 children in 1979 and 4.54 in
1949, well below the estimated 2.1 rate needed to prevent
the population from eventually declining. 13 The resulting
slower growth in the number of labor force participants
who save relative to the number of people entering retirement who dissave has lowered the overall level of private
saving.
With private excess savings relatively flat or falling for
much of the 1980s, most of the increase in Japan's net
capital outflows has been associated with an increase in
gdvernment saving (that is, government receipts minus
expenditures). Mainly because of reduced spending, the
Japanese government budget deficit has declined steadily,
since 1978, when it amounted to more than 8 percent of
GNP. It fell throughout the 1980s and turned into a small
surplus in 1988. This improvement in the government
budget balance reduced the public sector's demand for
domestic saving. Thus the shift in the flow of Japanese
government saving, combined with relatively high domestic private saving and investment, resulted in excess Japanese savings, in effect providing the resources for foreign
investment.
Since 1987, however, economic growth in Japan has
boomed. Domestic investment rose to meet more favorable
opportunities. As a result, the gap between private saving
and investment fell sharply to 2 percent of GNP in 1988.

(Later figures are not yet available.) The fall in the magnitude of Japan's current account surpluses and capital
outflows that began in 1988 can be associated with this
decline in excess savings.

Financing U.S. Budget Deficits
In a global context, Japan's capital outflows are net
capital inflows for the rest of the world. In the US., Japan's
largest external debtor, rising budget deficits from 1980 to
1985 and corresponding demand for capital in the U.S.
were also major factors in generating Japanese foreign
investment. 14 The US. budget deficit, which averaged
less than 2 percent of GNP in the 1970s, climbed to 5
percent df GNP following the 1981-83 tax cuts and defense
buildup. This in turn pushed up US. real interest rates and
attracted capitalfrom abroad, which induced the appreciation of the dollar against the yen. IS
The relationship between Japan and US. economic
activity is evident in trends followed by real long-term
interest rates during the 1980s. Chart 7 shows that US.
real interest rates (adjusted for expected inflation, as
proxied by the year-ahead actual change in prices) rose
sharply in 1981 and remained well above Japanese rates
over the first half of the decade.
The relatively higher return on US. financial assets
boosted ex ante demand for US. assets from abroad. Declining Japanese government borrowing, combined with
relatively loose monetary policy and falling interest rates
reduced the supply and attraction of Japanese domestic
investment outlets. This series of developments is consistent with the movement of net capital outflows from Japan

Chart 7
Japanese and U.S. Real Interest Rates
Percent

10
9
8
7
6
5
4

3
2
1
O-+----I-..:..---'l~'------_\___f--...,;------

-1
-2

-3 -+--+--,----,.-........--,---.,.----,r---r--,--.,..-----,
80

Federal Reserve Bank of San Francisco

to the U. S. as well as the appreciation of the dollar that
occurred from 1980 to 1985.
After 1985, however, the relative interest rate levels do
not appear to explain Japan's pattern of capital flows as
well. As observed earlier, Japan's net long-term capital
outflows jumped substantially in 1986 to levels well above
its current account surpluses. Short-term capital inflows
rose sharply as well. It is precisely at this point in time,
however, that U. S. budget deficits began to decline, U. S.
interest rates fell, and the dollar began to drop. Other
factors must therefore have been at work.

Other Macroeconomic Factors
Exchange rate expectations are another component of
the. overall rate of return expected by Japanese international portfolio investors and therefore of the relative
demand for dollar and yen assets. That Japanese investors
continued to desire to hold dollar-denominated foreign
assets after 1985 even though the U.S.-Japan interest rate
differential declined and the dollar depreciated can be
explained by the possibility that expectations of future
dollar depreciations were declining. In this instance, the
smaller expected decline in the future value of the dollar
against the yen would compensate somewhat for the lower
relative interest return to holding dollar assets. Indeed,
available survey evidence indicates that the expected oneyear-ahead depreciation of the dollar against the yen averaged almost 11 percent over the period June 1981 to
December 1985, and declined to 6 percent in October 1986
and to almost zero by February 1988.16
However, the results of more sophisticated empirical
analyses produce mixed results about the sensitivity of
Japanese foreign capital demand to exchange rate-adjusted
interest differentials. Kawai and Okumura (1988) found
Japanese capital outflows depended positively on the exchange rate-adjusted (nominal) interest rate differential
between the U.S. and Japan during the period 1982-1983,

but not during 1984-1987. Kawai (1989) found stronger
evidence. that Japanese stock demand for foreign financial
assets depended significantly on the interest differential
oyer the entire.period 1982-1987. Veda (1990), however,
found that the interest differential explained only a small
portion of .changes in the foreign securities component of
Japanese investment portfolios.
Another possible macroeconomic factor at work includes changes in perceived risk to holding foreign assets.
Specifically, the continued accumulation of dollar assets by
Japanese. investors, by leading to an undesirably large
share of dollar assets in their portfolios, may lead them to
curtail their demand or to compel larger risk premiums for
continuing to hold these assets. The econometric work
cited above, using various proxies for risk, has found
some evidence that since 1985 Japanese investors have
responded more significantly to exchange risk.
There were, in fact, several episodes during which
Japanese purchases of U. S. assets declined sharply. In late
1986 and early 1987, for example, anecdotal evidence
suggests that Japanese private investors appeared to reduce
their holdings of dollar assets markedly in response to high
perceived dollar exchange risk. This decline in Japanese
private investments was offset in part by an increase in
Japanese official intervention. By 1988, however, Japanese
private foreign investments"resumed at earlier high levels.
While macroeconomic factors, including interest rate
differentials, expected exchange rate depreciation, and
perceived risk have, to varying degrees, explained aspects
of Japan's pattern of capital outflows during the 1980s,
these factors do not appear to explain all aspects of Japan's
capital transactions. In particular, they do not fully explain
the sharp rise in Japanese capital outflows and the emergence of short-term capital inflows beginning in 1986. Nor
do they explain the behavior of institutional investors. To
explain these features, we turn to microeconomic and
institutional factors.

III. Microeconomic Determinants of Capital Outflows
Another major factor underlying the sharp rise in capital
outflows in Japan during the 1980s has been the ongoing
process of financial market liberalization. There were two
aspects of this liberalization process: domestic deregulation steps that led to greater competition for funds among
Japanese financial institutions, and the lowering of barriers
to the integration of Japanese financial markets with world
financial markets.
Domestic interest rate liberalization and the development of open securities markets in Japan beginning in the

late 1970s induced depositors to shift their funds from low
interest, fixed rate deposits to relatively high-interest,
floating rate funds. The deregulation process was accelerated following a May 1984 U.S.-Japan agreement outlining
specific actions for the Japanese government to liberalize
further its domestic capital market by deregulating interest
rates on large denomination deposits. l7
The continuing liberalization of domestic capital markets increased competition among Japanese financial institutions for funds and accounts. As a result, Japanese

Economic Review / Spring 1991

investors' demand increased for more opportunities to
obtain higher returns and diversify their portfolios both
domestically and internationally. Commercial banks, and
other institutions dealing in financial il1$truments still
subject to interest rates restrictions, suffered in their ability
to raise funds domestically relative to other intermediaries,
such as insurance companies and pension funds, which
were able to offer unregulated financial instruments.
The relaxation in the early 1980s of previously stringent
government controls on capital flows encouraged Japanese
foreign investment. The revision of capital control regulations with the enactment of the Foreign Exchange and
Foreign Trade Control Law in December 1980 generally
eliminated restrictions on individuals and nonfinancial
corporations, but ceiling restrictions on overseas investments by most Japanese financial institutions still
remained. 18
For example, investment trusts typically faced few or no
regulatory restrictions on foreign investments. 19 On the
other hand, life insurance and other insurance companies
were permitted to hold a maximum of 10 percent of their
assets in foreign securities (including yen-denominated
foreign securities). 20 Most other financial institutions were
prohibited from investing abroad. As a result, foreign
securities investment by institutional investors was very
limited. 21 For example, at the end of 1980 life insurance
firms held only 2.7 percent of their total assets in foreign
currency assets.
These restrictions were lifted gradually in the early
1980s. Pension trusts were allowed to hold foreign securities up to 10 percent of their assets in 1981. The Postal
Life Insurance System (Kampo) was permitted to invest in
foreign bonds up to 10 percent of its assets in 1983. 22 In
1984 holdings on foreign securities by certain trust funds
were relaxed.
However, high US. real interest rates and remaining
restrictions on institutional investors' behavior still pent up
demand among institutional investors for foreign assets. In
1986, Japan's Ministry of Finance moved to increase the
ceilings sharply and greatly expanded the opportunities for
financial institutions to invest abroad. The limits on holdings of foreign securities by life insurance companies and
pension trusts were raised from 10 to 25 percent of total
assets in March 1986 and to 30 percent in August 1986.
The ceiling for the Postal Insurance System was raised
from 10 percent to 20 percent in the same year. Also in 1986
loan trusts were allowed to invest up to 1 percent in
February and later (in June), up to 3 percent of assets in
foreign currency bonds. 23
As the authorities raised the percentage of institutional

Federal Reserve Bank of San Francisco

assets that could be invested, their foreign investment has
soared.· This trend suggests that much of the rapid growth
in Japan's foreign asset holdings during the 1980s, particularlyafter 1986, in part represents a stock adjustment
towards desired levels that for regulatory and other reasons
were not previously attainable.
The propensities of insurance firms and trust accounts to
invest abroad have been relatively high for several reasons.
In particular, they have accumulated large amounts of
fund.sto investastheaging of the population has increased
the demand for insurance and pensions. The elimination of
mosttax preferences on bank savings accounts in 1989 also
induced a rapid shift of funds available to life insurance
companies and trust funds. Consequently, over the last ten
years there has been an upward trend in the ratio of assets
in these institutions relative to the total assets of all
Japanese financial institutions.
In addition, these institutions have long investment
horizons and a strong preference for assets that bear high
interest as a result of accounting rules that have generally
limited· policy payouts by life insurance companies, in
particular, to coupon and dividend earnings from investments. 24 For most ofthe 1980s Japan's low inflation and
accompanying low interest rates made it difficult to obtain
high current returns by investing in domestic yen-denominated bonds. Moreover, most of the return on domestic
equities came in the form of capital appreciation rather
than dividends. This made investment in foreign currency
securities with high coupons and dividend yields attractive
for policy payoffs. 25 The desire to generate income from
interest payments spurred investment in relatively highinterest foreign bonds and high-dividend foreign stocks,
particularly in the US. for most of the 1980s, but also in
Canada, Australia, and the UK.26
Because of limits on allowable long-term foreign exchange exposure, Japanese bank purchases of foreign
currency denominated securities have been relatively small
in comparison to their total assets. At the same time
continuing restrictions on deposit interest rates in Japan
reduced the competitiveness of Japanese banks and their
ability to raise funds domestically. Consequently, the
growth of domestic demand deposits lagged behind loan
demand. To supplement their domestic deposits, Japanese
banks used borrowings from offshore branches in London
and the U.S. It is estimated that in 1987 one half to twothirds of the funds borrowed abroad by Japanese banks in
the U. S. were reloaned to parent banks in Japan (Terrell
1990). This accords with the pattern of significantly high
short-term capital inflows to Japan pointed out in Section 1.
However, beginning in 1988, continued liberalization of

deposit interest rates payable in the domestic Japanese
market increased the share of bank deposits with unregulated rates from less than 20 percent to almost 50 percent in

1989. As a result, foreign borrowing by Japanese banks has
diminished significantly. 27

IV. Future Japanese Capital Outflows
The rise in Japanese capital outflows during most of the
1980s is attributable to a combination of excess domestic
savings, U. S. budget developments, and Japanese financial
liberalization. The capacity and willingness of Japanese
investors to invest more in foreign assets, particularly in
the U. S. , depends on how prevalent these factors will be in
the future. Since 1988 there is evidence of significant
decline in Japan's current account surpluses and capital
outflows. This decline can be largely attributed to the
dramatic rise in domestic investment between 1987 and
1989, combined with a continued fall in savings. However,
extrapolating into the future is difficult.
Over the long run, the magnitude of Japan's excess domestic savings will depend significantly on demographic
factors affecting Japan's savings rate, on investment trends,
and on future Japanese government budget policies. Japan's birth rate is currently among the lowest in the world.
It is estimated that over the next 30 years Japan's labor
force could decline by as much as 10 million and that the
proportion of the population over 65 years old will rise
from its current level of 11.5 percent to above 20 percent. 28
The aging of the population is expected to reduce further
the level of Japan's saving as the older dissaving population
dominates the younger savers. This decline in saving in the
long run will tend to reduce Japan's capital outflows.
Future investment and government policy actions are
harder to project. Higher interest rates in Japan since 1989
have begun to dampen investment. The dramatic stock
market decline in the first half of 1990 presumably is also
having an adverse effect. Recent legislation intended to
expand future Japanese fiscal spending should tend to
reduce capital outflows. On balance, the excess of domestic saving over investment and new Japanese foreign investment should diminish during the 1990s.
The continued liberalization of Japan's financial markets
will probably be a less significant factor for capital outflows in the future. The deregulation of Japan's domestic
financial markets is continuing. However, barriers to international capital flows are virtually gone. In particular,
ceilings on foreign securities holdings of Japanese institutions are no longer binding.
It is difficult, however, to evaluate how much future
increase may occur in the desired portfolio share of foreign
investments by Japanese investors. Some idea can be
obtained by comparing Japanese portfolio share figures
with corresponding figures in other countries. It is esti28

mated that 6.5 percent of Japan's total secunties were
invested abroad in 1988, up from 4 percent in 1983. Even
so, Japanese investors remain less diversified than investors in a number of other countries. For example, investors
in the UK. and Germany held 22 and 15 percent, respectively, of their securities abroad. 0. S. investors held only 2
percent of their total securities holdings abroad, but this
may be attributed to the greater diversification benefits
provided by the US. economy.29 This evidence suggests
Japanese investors may want to diversify further into
foreign assets in the future.
Other available evidence compares the shares of foreign
investment in the total assets of private pension funds for
1980 and 1986 in several countries. This evidence indicates
that the international diversification of pension funds has
proceeded rapidly in the 1980s. In 1986, the UK. had the
highest share (20 percent) followed by Australia (15 percent); Japan held 10 percent. However, all other countries,
including Canada, Switzerland, Germany, the 0. S., and
France, had lower shares than Japan. On the basis of this
evidence, it is difficult to expect a continued rapid rise in
the share of foreign investment by Japanese institutional
investors in coming years. (See Fukao and Okina (1989».
Even without any further increases in the portfolio share of
these investments, the magnitude of foreign securities
purchases by Japanese institutional and noninstitutional
investors is likely to remain high in the near future, as
long as these institutions continue to receive new funds for
investment.
In the near term, most Japanese investments should
continue to be in dollar-denominated assets because of the
relative thinness of other markets. Thus the desire of
Japanese investors to acquire additional dollar-denominated assets at current yen exchange rates and interest
differentials should not be underestimated. Nevertheless,
Japanese purchases of U. S. securities likely will grow
more slowly in the medium and long term as Japanese
investors adjust their portfolios to include more European
currency-denominated assets in light of developments in
Europe, including the reunification of Germany and ongoing European Community financial reforms. Consequent1y' the 0. S. will face greater global competition for funds
than in the past. Accordingly, the terms of external finance
for the United States may not be as favorable as in recent
years.

Economic Review / Spring 1991

NOTES
1, See, for example, Reinhardt (1986),
2, Figures for 1990 are for the first three quarters of the
year and are expressed at an annual rate,
3, Japanese international transaction statistics follow a
nationality definition of residency, Thus, for example,
bonds issued outside Japan by Japanese residents are
recorded as capital inflows, In contrast, U,S. international
transaction statistics follow a geographic definition of
residency. Consequently, they do not define bonds issued
Qutside the U.S. by U,S. residents as capital inflows.
4, .In 1986 and 1987 net long-term capital outflows averaged more than 6 percent of GNP,
5. There is some past evidence of a seasonal increase in
demand for foreign assets by Japanese investors, Hence
the annualized figures for 1990 based on data forthe first
three quarters of the year may underestimate the figures
for the full year,
6, Japan's capital flow figures have become more difficult
to interpret as more foreign securities investment takes
place through the foreign subsidiaries of Japanese financial institutions, such as life insurance firms and trust
banks, These flows are often reported either as direct
investment flows or as loans from parent firms in Japan,
rather than as securities investment flows, It is estimated
that roughly one-half of all transactions by trust banks and
one-third of all transactions by life insurance companies
are conducted directly with overseas securities companies (Okumura, 1988), Thus some of the rise in gross
direct Investment and loan outflows from Jaoan (incltJrlArl
in the "Other" category in Charts 2 and 3) in recenty;;r~
may be due in part to these transactions,
7. A small portion of long-term foreign securities purchases are for bonds issued pUblicly in Japan by nonresidents, primarily denominated in yen (samurai bonds),
8, In 1988 and 1989, purchases of Japanese bonds also
rose sharply, primarily due to a rise in the issuance of
external bonds, i,e" yen-denominated or foreign currency-denominated bonds issued outside of Japan by
residents,
9, It should be noted that these overseas investment
figures from the Ministry of Finance exclude yen-denominated foreign bonds issued by nonresidents in Japan
(samurals), but Include foreign-currency denominated
bonds issued by nonresidents in Tokyo (shogun bonds);
the former are included in the Bank of Japan capital
outflow statistics contained in earlier charts,
10, A major factor for the surge of investments in the U,S,
in, 1985 "'!as the abolition in June 1984 of the 30 percent
withholding tax on U,S, bonds held by foreign investors.
11, Much of the Eurodollar securities purchased by Japanese investors are in fact issues by Japanese firms.
Investment in Eurodollar bonds was particularly facilitated
by the liberalization in April 1984 of the conditions under
which foreign-currency denominated bonds could be issued by Japanese residents, This allowed Japanese firms

Federal Reserve Bank of San Francisco

to .issue them as swap bonds, that is bonds combined
with long-term forward currency contracts, The Eurodollar
bonds thus issued have been largely purchased by Japanese institutional investors.
Between 1987 and mid-1989 Japanese firms issued
nearly $100 million in Eurodollar warrant bonds, which
gave investors the right to buy the issuing firm's stock at a
set price during a specified period, During the Tokyo stock
market boom, warrant bonds provided Japanese firms a
relatively inexpensive way to raise money, since investors
were willing to accept lower interest payments in exchange for the right to buy stock below market prices,
Most of these warrant issues were in fact repatriated and
repo~ed as foreign bond and equity purchases by Japanese Investors, Adjusting net foreign securities purchases
for warrant repatriation reduces estimates of Japanese
Investment abroad by $5 to $10 billion each quarter in
1989. See Napier (1989),
12, Net household saving in Japan fell from a peak of 23
percent of disposable income in 1976 to 18 percent in
1980,16 percent in 1985, and 15 percent in 1989. In 1989
the household saving rate was 12 percent in Germany and
France, 6 percent in the U,S., and 5 percent in the UK
(OECD Economic Outlook, June 1990, Table R 12, p. 192.)
It should be noted that aggregate private savings include
corporate retained earnings in addition to household
savings,
13, The corresponding figure in 1989 was 1,87 forthe U,S,
and 1,28 for West Germanv. (U.S. News and World RAnnrt
December 24, 1990 and 'Economist, January

26', '1991):

~4.

Glick (1988), using a two-country model of saving and

Inv~s,tment b~havior, estimates that the rising U,S, bUdget

defiCits explained roughly half of the increase in Japan's
current account surplus between 1981 and 1986.
15. An alternative explanation sometimes given for the
increase in U.S, real interest rates in the early 1980s is that
U,S, investment demand increased in response to the
more favorable treatment of business fixed investment in
the 1981 tax bill, However, the supporting evidence for this
view is doubtful. See Frankel (1988),
16, The survey evidence comes from the Economistaffiliated Financial Report, See Frankel (1988). That the
dollar actually depreciated continuously against the yen
from its peak in February 1985 through the beginning of
1988 resulted in significant foreign exchange losses for
Japanese investors in U,S, assets,
17, The terms of the agreement were released in a document called the "Report of the Joint Working Group on
Yen/Dollar Exchange Rate Issues,"
18, Evidence of the role of the existence of residual controls on capital outflows from Japan is provided by the
existence of a negative differential between the 3-month
Gensaki interest rate that could be earned in Tokyo and
the 3-month Euroyen interest rate that could be earned
offshore in London, See Frankel (1984),

19. One set of funds, Domestic and Foreign Security
Funds (Naigaisai) can invest both at home and abroad
without any ceilings at all on foreign securities holdings.
Other funds are limited to having no more than 50percent
of their total assets in foreign investments. Tokkin funds, in
particlJlar, face no restrictions on investing inhigh.yield·
ing foreignbond$.
20. Foreign.currency·denominated domestic bonds and
foreign· currency deposits were not subject to this limit.
Between 1982 and 1986 limitations also applied to allow·
able increases. in the purchase of foreign bonds as. a
percentofthe increase .in total assets; these limits were
dropped in 1986. Atthe same time, limits on otherforeign
currency assets, such as deposits, real estate, and for·
eign clJrrency denominated. domestic. bonds. isslJed. by
Japanese firms {sushi bonds) became subject to the
same limits in relation to total assets.
21. One response to the 10 percent limit on the assets
of insurance and pension funds that could be invested
abroad was investment in foreign currency·denominated
bonds issued by Japanese firms abroad (sushi bonds).
Such issues were treated as domestic issues in Japan
and hence were not subject to the ceilings on foreign
investment.
22. This limit did not include yen·denominated foreign
bonds in the case of pension trusts. Capital outflow re·
strictions on the Postal Insurance system and the Postal
Savings System are set by the Ministry of Posts and
Telecommunications, not by the Ministry of Finance.
23. Investment in either domestic or foreign stocks is not
allowed by loan trusts. The foreign investment ceiling for
loan trusts was raised to 5 percent in 1989.

24. Capital gains from stock and bond purchases, could
not be used for policy payments, but they could be used to
offset foreign exchange losses.
25.·· One way··. around the restriction on capita! gains
was through foreign subsidiaries since profits repatriated
through subsidiaries are considered income instead .of
capital gains. Asa reslJlt,a number of Japanese life
insurance firms have established. foreign subsidiaries.
26.• Because of their relatively low interest rates for most of
the 1980s, OM and Swiss franc assets make up a neglig·
ible share. of foreign securities holdings.
The capital gains restriction has led to charges that
Japanese companies have at times played havoc with
certain U.S. stocks that pay high dividends, such as utility
companies. Japanese firms have often bought and sold
foreign stocks simply to obtain the dividend payment,
even.ifit meant taking a capital loss. The companiesblJY
the stock just in time to claim the dividend and then sell it at
a capital loss. Because more than one company has been
able to claim the dividend on a single share of an Ameri·
can company on the same day, trading in such stocks was
often remarkably heavy on the days in question.
27. To some extent shorHerm borrowing by Japanese
institutions may also be associated with strategies to
hedge foreign·exchange exposure of long·term foreign
asset positions. The decline in foreign borrowing since
1988 may reflect greater use of off·balance sheet hedging
strategies involving, for example, forward contracts.
28. U.S. News and World Report, December 24,1990.
29. J.P. Morgan, World Financial Markets, November 22,
1989, "Government Bonds and Global Diversification."

Economic Review / Spring 1991

REFERENCES
Deguchi, H, 1987, "Changing Life Insurance Companies"
[Ookina Henbo 0 Togeru Seiho Kin'yuu Gyomu], In
Changing.Life Insurance: A Vision for the 21st Century (Henbosuru Seimei Hoken: Nijuu Isseikieno
Vision), ed, K. Seki. Tokyo: Kinzai,
Frankel, Jeffrey, 1984, The Yen-Dollar Agreement: Liberalizing Japanese Capital Markets, Washington, D,C:
Institute for International Economics,
Frankel, Jeffrey, 1988, "Factors Determining the Flow of
Capital from Japan to the United States," Working Paper No, 8872 (April). University of California, Berkeley,
Fukao, Mitsuhiro, and Kunia Okina. 1989, "Internationalization of Financial Markets and Balance of Payments
Imbalances: A Japanese Perspective." CarnegieRochester Conference Series on Public Policy 30,
pp. 167~220,
Glick, Reuven, 1988, "Saving-Investment Determinants of
Japan's External Balance." Federal Reserve Bank of
San Francisco Economic Review (Summer) pp.3-14,
Kasman, Bruce, 1987, "Japan's Growth Performance over
the Last Decade," Federal Reserve Bank of New York
Quarterly Review (Summer),
Kawai, Masahiro, 1989, "Japan's Demand for Long-term
External Financial Assets in the 1980s," Institute of

Federal Reserve Bank of San Francisco

Social Science Occasional Papers (March). University of Tokyo. Forthcoming in the Annals of the Institute
of Socia/Science,
___-__.' and Okumura, Hirohiko. 1988. "Japan'sportfolio Investment in Foreign Securities," Research Paper No, 9 (January), Japan Center of International
Finance.
Napier, Ron, 1989. "Japanese Long-term Capital Outflow
Declines in 1989," Mimeo (August 16). Japanese
Stock Research, Market Analysis, Salomon Bros,
Okumura, Hirohiko, 1988. "International Money Flows and
Capital Exports Through Portfolio Investment in Tokyo
Financial Markets," Paper presented to U.S.cJapan
Consultative Group on International MonetaryAffairs,
December 1-2, Washington, D.C.
Reinhardt, Vincent. 1986, "Macroeconomic Influences on
the U.S,-Japan Trade Imbalance," Federal Reserve
Sank of New York Quarterly Review (Spring) pp. 6-11,
Terrell, Henry, 1990. "Statement before the Task Force on
the International Competitiveness of U,S. Financial
Institutions," U,S, House of Representatives, Committee on Banking Finance and Urban Affairs (August 2),
Ueda, Kazuo, 1990, "Japanese Capital Outflows," Journal
of Banking and Finance pp, 1079-1101,

Interstate Banking and Competition:
Evidence from the Behavior of Stock Returns

Elizabeth S. Laderman and
Randall 1. Pozdena
Economist, and Vice President, Banking and Regional
Studies, respectively. The authors have benefited from the
comments of the editorial committee, Frederick Furlong,
Sun Bae Kim, and Mark Levonian. We also would like to
thank Deborah Martin for her skilled, enthusiastic, and
dedicated research assistance.

In this paper, we empirically examine the response of
bank holding company stock returns over the period 1964
to 1989 to changes interstate banking laws. We find that
returns respond negatively and significantly to an increase
in the number ofeligible source states from which acquiring banking firms can enter the bank holding company's
headquarters state. In addition, the negative effects are
stronger in the absence of reciprocity requirements and
weaker in the presence of a market that already is relatively competitive. We conclude that interstate banking
tends to enhance potential and/ or actual competition
in state banking markets, particularly those formerly
restricted.

Since the late 1970s, many states have enacted interstate
banking legislation. These laws permit bank holding companies headquartered in selected other states to operate
bank subsidiaries in their state. Recently, bills have been
introduced in Congress to liberalize interstate banking
laws to permit banks to operate their own branches across
state lines. l
Proponents of such legislation argue that complete elimination of interstate banking restrictions would generate
some significant benefits, including a more efficiently
configured banking industry, and would invigorate competition in the commercial banking market. Opponents are
concerned that interstate branching would lead to excessive concentration and ultimately to a less competitive
banking market.
In this paper, we examine the effect of liberalization of
interstate banking by studying individual bank stock returns over the period 1964 to 1989. The patchwork liberalization of interstate banking laws over this period had the
effect of varying the number of states from which bank
holding companies could enter various state markets. We
find that individual bank stock returns reacted negatively
to these legislative changes, consistent with the hypothesis
that interstate banking increases potential and/ or actual
competition. For banks in general, this negative effect on
returns appears to be stronger than any positive effects that
would stem from potential economies of scale or scope or
from the benefits of asset diversification.
The remainder of the paper is divided into five sections.
In Section I, we discuss the legal background of interstate
banking laws. In Section II, the theory regarding the
potential effects of interstate banking is presented and we
present the findings of previous researchers. Section III
discusses the methodological approach that we employ,
and the data used. We present the empirical findings in
Section IV, followed by a discussion of policy implications
in Section V.

Economic Review / Spring 1991

I. The L egal B ackground o f Interstate B anking

Interstate banking restrictions originate in laws passed
earlier this century. The McFadden Act, originally passed
in 1927 and amended in 1933, effectively prohibited inter
state branching by giving the states, not the federal gov
ernment, the power to decide whether any bank could
establish branch offices within their borders. The McFad
den Act has been interpreted to say that if state law is silent
on the issue of interstate branching, then out-of-state banks
are prohibited from establishing branches in-state.
The McFadden Act left open the possibility of a bank
holding company having separately chartered bank sub
sidiaries in more than one state. This mechanism of inter
state banking was foreclosed, however, by the Douglas
Amendment to the 1956 Bank Holding Company Act. The
Douglas Amendment prohibited bank holding companies

from acquiring or establishing banks outside their home
office state unless the laws of the state in which the bank
was to be acquired or established explicitly provided for
such entry. In effect, therefore, state law presently deter
mines the extent of interstate banking.
Recent Liberalization
Beginning in the late 1970s, states have passed interstate
banking laws that explicitly provide for the entry of out-ofstate bank holding companies.2 The mechanisms per
mitted by these changes in law involve outside ownership
of in-state bank subsidiaries. It is important to note that
these laws do not permit out-of-state banks to set up or
acquire in-state branches. There are three main distinc
tions to be made among interstate banking laws. The first

Chart 1
E ffective Dates fo r in te rsta te Banking Laws
North Central

North East

198 0 -

1975

West

1975
CT

South

Year

1995-,
1990
1985
1980

1975
AK AZ

CA CO

IMV N M O R

UT W A W Y

1975
AL AR DE DC FL GA KY LA MD MS NC OK S C TN TX VA WV

c3 N o L a w

■ R eg io n al R ec ip ro ca l

m N atio n al R e c ip ro c a l

n N a t io n a l N o n r e c i p r o c a l *

*Law Implemented Allowing De Novo Entry
Numbers represent the number of eligible source states for regional
reciprocal laws.
(GA, IN, MD, MN, and MS changed their laws to increase the
number of eligible states.)
Federal Reserve Bank o f San F rancisco

pertains to the geographic extent of the zone from which
out-of-state bank holding companies may enter. Under
"regional compacts," entry is permitted only from states
in a surrounding region, with the boundaries of the region
determined by the state passing the law. On the other hand,
national interstate banking laws designate the entire country as the eligible region.
The second distinction pertains to whether the interstate
banking law requires "reciprocity." All of the existing regional compacts and some of the national laws limit entry
to those states in the eligible region that permit bank holding companies from the "host" state to enter their state. 3
The third distinction pertains to the permissible means
of entry. Some states permit entry via establishment of a
new (de novo) bank subsidiary, while others require that
entry be via acquisition or merger with an existing institution. It appears that all states that permit de novo entry also
permit entry via acquisition. 4
Many states have changed their original interstate banking laws. The effective dates for the different types of
interstate banking laws for each state are shown in Chart
1. 5 In Chart I, interstate banking laws are presented by

region. Because many of the laws are regional reciprocal
laws, this makes it easier to estimate the number of actual
eligible source states as opposed to potential source states.
As seen in Chart 1, changes have all been in the direction of
liberalizing the restrictions on entry. For example, a state
may move from a regional reciprocal law to a national
reciprocal or national nonreciprocal law, or from a national
reciprocal law to a national nonreciprocal law.
Chart 1 also shows the number of eligible "source
states."6 As seen in Chart 1, some states have enlarged
considerably the number of potential source states in their
regional compact over time.
Currently only Utah, Nevada, Rhode Island and Virginia
permit interstate branching. 7 As stated in the introduction,
though, legislation has been introduced in both the House
and the Senate to repeal the McFadden Act, which would
allow U.S. banks to branch nationwide irrespective of state
law. The effect of such legislation, should it be adopted, is
an open question. One purpose of this paper is to examine
the experience of states with various types of interstate
banking laws in order to infer the effects of interstate
branching.

II. Theory and Previous Research
Because the empirical research in this paper concentrates on an examination of bank holding company stock
returns, which depend on profitability, our discussion
centers around the effect of interstate banking on bank
profits. However, underlying the profitability effects are
effects on bank costs and competition and accompanying
effects on the consumer of bank services. By examining
bank profitability, we hope to infer the relative importance
of these potential cost and competition effects.
Theory suggests that interstate banking may either raise
or lower bank profits. For example, interstate banking may
raise profits by lowering costs, either through scale or
scope effects or through diversification effects. First, to the
extent that interstate banking restrictions are binding,
banks may be forced to operate at a suboptimal scale or to
offer a suboptimally limited range of services. Relaxation
of the restrictions, therefore, might permit banking organizations to operate at a more efficient scale and with a more
efficient scope. As. a result, banks would have lower
operating costs and, in the short run at least, higher profits.
In the long run, though, we could expect at least some of
these profit gains to be competed away, as consumers face
more favorable prices.
A second effect of interstate banking on costs may arise
from the diversification of bank portfolios. To the extent
that bank portfolio risk is nonsystematic and that returns on

any nevv' assets are not perfectly positively correlated with
the return on the existing portfolio, the expansion of
business opportunities introduces the possibility of
ing risk iJy diversifYing. If bankruptcy costs are at
partially· borne by the bank, and if diversification is
costless, then diversification raises expected profits and
may eventually benefit consumers, too. 8
Geographic diversification may not be without costs,
however. The management of loan assets requires administrative input, monitoring of the borrower, and implementation of covenants and terms. Depending upon the
costliness of these activities, the pure diversification advant(iges could be offset by the costs of administering and
monitoring such varied and far-flung loans. Thus, like the
scale economy effects, the effective impact of diversificationadvantages of interstate banking is ultimately an
empirical issue.
Interstate banking may affect profitability through its
effect on costs, as just discussed, or through
on
competition. Theoretically, interstate banking could
strengthen competition, and lower profits, or weaken competition, and raise profits. On the one hand, interstate
banking could lower profits by increasing the threat of
competitive entry in regional banking markets. For examif
ple, incumbent banks may enjoy above normal
they can set "limit" prices that are above the competitive

Economic Review / Spring 1991

level but low enough to deter entry. Entry will be deterred if
there are significant learning economies, set-up costs, or
other barriers that make entry into the region at or below
the limit price unprofitable. 9
By permitting entry from a larger pool of existing bank
holding companies, the relaxation of interstate banking
restrictions increases the probability that one of the pool
will have low enough costs or a large enough store of
wealth to enable the bank to enter and undercut the
incumbents. Anticipating this, incumbents may lower limit
prices in response to interstate banking liberalization, and
thus experience lower profits. If they do not, the market
may expect that actual entry will increase. Either way, the
expected value of future profits will decline, to the benefit
of consumers.
On the other hand, the mergers and acquisitions facilitated by interstate banking or branching could lead to a
reduction in the number of banks in the nation and,
thereby, decreased competitiveness and increased profitability. While this effect is possible, it relies on the assumption that the relevant geographic market is the nation as a
whole. It seems likely, however, that the relevant market,
for consumer or retail banking services, at least, is smaller
than the nation. 10 Thus, even if interstate provisions decrease the number of banking firms in the whole country,
they do not necessarily decrease (and may increase) the
number of banking firms in competition for a region's
consumers. Some banking products, of course, likely have
effective markets larger than a region; business lending,
for example, is probably not locally confined. For such
services, it is possible that interstate banking would
not increase competition, although foreign competition
likely provides a safety valve against undue concentration
of power.
We have discussed several hypotheses regarding the
effects of interstate banking, but there are only two possible effects, if any, on profits-they will either go up or
down. In our empirical work, we will study the effect of
interstate banking on bank profitability and returns. If we
observe that profits go up, it may be because interstate
banking decreases costs, or decreases competition, or
both. In this case, the effect on consumers would be
ambiguous. However, if profits fall, this will suggest an
increase in potential or actual competition, which would
unambiguously benefit consumers.
A number of previous studies have attempted to evaluate
the effects of interstate banking. In general, this prior
research has focused on the portfolio or stock price performance of banks involved in mergers or acquisitions, or
the comparative performance of interstate and noninter-

Federal Reserve Bank of San Francisco

state banking firms. We will now review some of this
past work.

Cost Effects: Economies of Scale and Scope
Born, Eisenbeis, and Harris (1988) examined bank
acquisition announcements. Using a standard market
mociel of stock returns, these authors looked at whether the
announcement of an agreement to acquire an out-of-state
bank causes "abnormal returns" for the acquiring bank
holding company.11 They find no effect, and state that this
suggests either that there are no benefits to interstate
banking, or that the benefits are distributed to the shareholders of the acquired firm, as is the case in general,
industrial mergers. 12
Goldberg and Hanweck (1988) look directly for economies-of-scope advantages in interstate banking. These
authors found that grandfathered interstate banking firms
did not enjoy any long-run competitive advantage, in terms
of market share or profitability, over similar sized noninterstate banking firms. Goldberg and Hanweck conclude
that interstate banking firms, although they have the opportunity to engage in a wider range of activities, are not
in general more efficient than comparable noninterstate
banking firms. 13
This finding is consistent with the conclusions of numerous, more general studies that have found that economies
related to scale or scope are relatively small. For example,
Berger and Humphrey (1990) used actual average costs for
all insured commercial banks in 1984 to estimate the
contribution of various factors to differences in average
costs. They estimated differences of 25 percent or more in
average costs between the highest and lowest cost groups
of banks due to inefficient management, and differences of
only 5 percent or less due to scale or product mix.

Cost Effects: Diversification
Other studies have examined the effect of diversification
on bank performance. Liang and Rhoades (1988), for
example, investigated whether increases in the geographic
dispersion of bank offices decrease the probability ofbank
insolvency. Specifically, they examined whether the portfolio effects of asset diversification were outweighed by the
effects of an increase in .administrative and monitoring
costs for the new assets. Liang and Rhoades' empirical
results supported the conclusion that geographic disper~
siondoes reduce the probability of bank insolvency.14
Should insolvency costs be partly borne by banks, this,.in
turn, would imply that banks diversified interstate would
enjoy cost advantages over nondiversified banks. Liang

and Rhoades also report, however, that geographic diversification was costly to administer; while reducing earnings variance, it also reduced average earnings. On net,
though, diversification was not found to decrease the
market value of the banking firm.
Evidence pertaining to the relationship between the
geographic dispersion of bank offices and actual bank
failures can be found in the work of Hilary Smith (1987).
Using data from actual bank closures, Smith finds empirical evidence that intrastate branching restrictions, which
limit branching to a confined area, increase the incidence
of bank closure. One may reasonably extrapolate from this
result to say that interstate banking has the potential to
decrease the probability of bank closure.
Effects on Competition
In addition to effects due to economies of scale or scope,
or geographic portfolio diversification, interstate banking
may have an effect on the level of actual or potential
competition. Adkisson and Fraser (1990) examined the
effect of interstate banking laws on premiums paid in
actual bank mergers, whether or not the merger was across
state lines .15 They hypothesized that interstate banking
could have two countervailing effects on bank merger

premiums in general. First, they say, interstate banking
may increase competition, thereby lowering the market
value of previously protected banking firms and lowering
merger premiums. Second, they maintain, interstate banking may increase the number of potential bidders for a
particular firm, thereby increasing merger premiums.
Adkisson and Fraser find that the second effect dominated the first effect; that is, bank merger premiums were
larger in states that permit interstate banking. This does not
mean that competitive effects are absent, of course, but
only that they may be overpowered by the effects of rivalry
among potential bidders for the (self-selected) sample of
banks acquired. By focusing on actual mergers, therefore,
the Adkisson and Fraser study cannot answer the broader
question of what happens to overall levels of competition in
bank product markets.
In summary, the available studies suggest that there are
at best modest economies of scale and scope effects, but
that the diversification effects of interstate banking may
be significant. 16 However, it remains an open question
whether interstate banking significantly enhances competition. To address this question, it is necessary to study the
effects of interstate banking on all banks, not just those
selectively involved in merger and acquisition activity.

HI. Methodology and Data
The methodology employed in this paper is designed to
determine whether relaxation of interstate banking restrictions enhances competition in commercial banking, or,
alternatively, degrades competition and/or enhances efficiency. As explained above, these two alternatives would
be expected to have opposite effects on bank profitability.
Conceptually, we could make this determination by examining bank performance at a portfolio level before and after
changes in interstate banking legislation. The prices of
bank products and the level of bank profits could be
examined for evidence of effects on costs and competition.
Unfortunately, the quality of price and portfolio information on commercial banks is not sufficient to support
such a study. Bank product prices are difficult to obtain,
and are not easily separated from changes in other, qualitative dimensions of bank products. Similarly, bank balance
sheet and income statement data offer only imprecise
measures of actual costs, net worth, and earnings because
of the use of book value accounting practices in banking.
Those data need to be studied in detail each quarter bank
by bank, as is done by private bank stock analysts,
to derive more accurate estimates of actual bank performance.
Consequently, we have chosen to study the effect of

interstate banking on costs and competition by using data
on bank stock price behavior. We would expect changes in
profits to be capitalized in share prices and thereby show
up as changes in returns. This approach implicitly relies
upon the analytical assessments of the marketplace, which
likely incorporate a greater information set than that available to the researcher. To the extent that stock markets
efficiently incorporate this information, therefore, this
approach offers greater potential precision than the direct
study of prices or portfolio data.
There are important drawbacks to this approach, however. First, the stock price methodology confines our study
to the set of banks with traded equity. At present, useful
stock price data are available for fewer than 200 banking
organizations. These organizations account for over 85
percent of total banking assets or deposits and, hence, the
effects on these banks likely are the dominant effects in
the banking marketplace generally. However, the selfselected nature of our sample implies that the results of
our study are not easily generalized to the over 14,000
smaller. institutions we were unable to study, and may be
biased by large bank-specific effects. I7 Additionally, the
relatively thin sample of banks limits the degree of detail
on the regional banking environment that can be em-

Economic Review / Spring 1991

ployed, because some smaller regions are not represented
by traded banks.
The basic analytical method thus relates individual bank
stock returns over time to variables representing the legal
environment and general stock market conditions. The
following basic system of equations describes the statistical analysis in this paper:

0)
where
the dividend-adjusted stock return for bank i in
quarter t, measured using the closing stock price
at the end of the quarter

R it

(Price;t - Price it __

Dividendit)/Price it _

D it

a vector of variables, including dummy variables, that describe changes in laws in period t

the general stock market return

eit

a disturbance term

and a, b, and c are estimated coefficients.1 8

Econometric Issues
A number of econometric issues arose in deriving a
practical estimation relationship from this specification.
First, it was anticipated that the effects of changes in the
law would be unlikely to be captured by a simple, contemporaneous dummy variable. It is likely that effects of the
laws would be anticipated, and that the full expected
effects on competition would take time to materialize.
Consequently, leads and lags of the explanatory variables,
in addition to contemporaneous levels, were employed in
the final specification of (1).19 To economize on model
parameters, a third-degree polynomial structure was imposed on the distribution of lead and lag parameters. 20
Second, the issue arose of whether to use effective dates
or passage dates for the law change variables. One might
argue that, in a market with rational expectations, the
effects of the implementation of a law would be fully
capitalized into stock prices when the law is passed,
or even prior to that. On the other hand, we have little confidence that we can determine the appropriate
"announcement date," given that many analysts and insiders may have reliable information prior to when the law
is actually passed. In contrast, the effective date of the law
is precisely determined. Given these considerations, we
estimated regressions using both the passage date and the
effective date. However, we report detailed regression
results for the effective date only.

Federal Reserve Bank of San Francisco

Third, since the data environment is one of a pooled
time-series of cross-sections (i.e., banks), the issue of
efficiency of the coefficient estimates arises. The direct
estimation of (1) on pooled time-series and cross-section
data can result in inefficient (but unbiased) parameter
estimates unless the coefficient vectors a, b, and c are
constant across banks and over time. Unfortunately, the
most general techniques for addressing this problem are
not emplOYable here because of our sample size, given our
need to employlagged explanatory variables. However, by
introducing dummy variables for each time period and
bank in equation 0), the importance of the cross-sectional
and time-series parameter variation can be explored in a
limited way in our sample. 21
Fourth, it is unlikely that bank stock prices, or stock
prices generally, are in equilibrium over time about a
constant mean level. Thus, it is likely that the chance of a
particular positive or negative deviation in stock prices has
varied across our sample time period, which includes
several record bull markets. The lack of stationarity can
also be a source of inefficiency in parameter estimates.
Most economic time series, however, can be made acceptably stationary by first-differencing. This is the rationale in
0) above for studying returns, rather than stock prices, in
the model.
Fifth, unbiased estimation of the parameters on the
interstate banking law variables, D, requires that the
passage of these laws be statistically exogenous to the
stock return variable. Similarly, the bank structure variables, S, also must not be endogenous to bank stock
returns. In practice, it is unlikely that significant banking
legislation or other structural aspects of banking markets
are determined completely independently of the characteristics and condition of a region's banks. Thus, there is
the potential for self-selection or simultaneous equations
bias to be introduced if the law dummies are treated as
exogenous.
In the context of this study, however, it is unlikely that
this bias is significant since stock prices are likely to have
capitalized any cross-sectional variations in legislative
control by the banks; legislative changes likely take place
in reaction to broader regional economic and banking
conditions, and not quarterly variation in stock returns.
Thus, in a statistical sense, the effect oflegislative changes
on stock returns is likely to dominate the reverse effect.
Finally, in a time series setting, the issue of bias in
attrition or entry into the dataset must be considered. That
is, banks that leave the sample (by failure or merger) or
enter the sample (by virtue of being a new bank or by newly
offering shares for public trading), may be different from

other banks. In the context of this study, attrition and entry
are hypothesized to be an integral part of the process that
will affect stock returns' reaction to interstate banking
laws. Hence, no control for sample attrition or entry is
attempted.

Data Considerations
An extensive database was assembled to test the effect of
interstate banking laws on bank returns. Bank stock returns data were obtained from the Compustat data file. This
data file contains share price and returns information for
about 150 leading U. S. bank holding companies during the
period 1964 to 1989. 22
The resulting data are comprised of the quarterly observations on 174 bank holding companies. 23 Returns are
calculated using the closing stock price at the end of the
quarter (adjusted for stock splits) and the common dividend paid per share by the ex-dividend date. The CRSP
tapes were used as the source for the overall market returns
variable used in the empirical work discussed below. The
daily returns on the Standard and Poor's Composite Index
were converted to quarterly returns by summing the daily
returns in each quarter.
Information on interstate banking laws was assembled
from numerous sources, including a table from the Banking
Expansion Reporter, a fact sheet obtained from the American Bankers Association, and Baer and Gregorash (1986).
Specifically, data was assembled on features of the various
state laws affecting interstate banking, and the dates of
passage and the effective dates of these laws. The laws
were classified as to their reciprocity conditions (Reciprocal versus Non-reciprocal), and their entry restrictions
(Acquisition versus De Novo). 24 In addition, the number of
potential and actual "source" states was calculated for
each state at every point in time. Much of this information
is summarized in Chart 1.
Information also was assembled on one aspect of the
structural characteristics of banking markets.. Specifically,
information on intrastate branching restrictions for the year
1983 was obtained from the Annual Statistical Digest of the
Federal Reserve Board of Governors. 25

Anticipated.Effects
The theoretical and data considerations resulted in an
empirical implementation of (1) in the form of an ordinary
least squares regression of bank stock returns on the
explanatory variables in Table 1.
The emphasis of the estimation of the effects of the laws
is on the variable called Change in States. 26 This measures

the increase in the number of potential source states that
results from the change in the law. (If there is no increase in
the number of source states in this quarter over last quarter,
this variable is zero.) If the market expects that interstate
banking will have the predominant effect of increasing
home state bank competition, an increase in Change in
States should result in a reduction in returns to bank equity
holders, and a negative sign on this variable. (In Table 1,
column 3, this is referred to as the Rent Depleting Model,
orRDM.)
Alternatively, liberalization could be perceived as working to the advantage of home banks by permitting them (to
the extent they activate other states' reciprocal laws) to
enter more states, thereby enhancing profits through diversificationeffects, or perhaps through scale or scope effects.
Likewise, because liberalization would broaden the pool of
potential acquirers, it might increase the potential diversification, scale, or scope benefits of merging with home
banks. Finally, if competition were to decrease, surviving
banks would all see increased rents. Whether such benefits
would show up in the stock returns of home banks as
acquirers, or as acquirees, this Rent Enhancing Model
(REM in Table 1) would predict that the coefficient on the
Change in States variable would have a positive sign. 27
Note that the structure of the model implies that a
positive change in the number of source states will have a
stronger effect, the greater the change. This is consistent
with the hypotheses discussed above regarding the sources
of interstate banking's potential effects on costs and/or
competition.
The two main variations in interstate banking laws are
whether the law requires reciprocity and whether the law
permits de novo entry. The effects of these variations are
studied by interacting dummy variables with the Change in
States variable.
The coefficient on the variable that interacts Change in
States with the Reciprocal Dummy should reveal the extent
to which reciprocity requirements influence the effectiveness. of the increase in the number of source states. 28 The
reciprocity requirement essentially makes the actual numberof source states less than the potential number represented by the Change in States variable. To the extent that
the main effect of interstate banking is pro-competitive
(the Rent Depleting Model), we expect the sign on this
interaction term to be positive. From the viewpoint of a
home state bank as an acquisition target, however, reciprocity requirements limit the potential benefit to be
gained from being acquired and, therefore, may modify
any increase in stock price due to the Change in States
variable.

Economic Review / Spring 1991

For our purposes, the other main distinction among
interstate banking laws is whether they permit. de novo
entry.29 From the standpoint of the Rent Depleting Model,
allowing de novo entry would be expected to enhance the
pro~competitive effect of liberalization by affording an
alternative means of entry beyond direct acquisition. A
negative sign then would be expected on the interaction of
the De Novo Dummy with the Change in States variable.
pnlctl:ce, however, the de novo feature of interstate
banking laws is unusual, and in our data set of traded bank
stocks, data on the banks of Ohio, New York, and New
Jersey dominate the actual instances of affected banks
(although more states permit de novo entry). Thus, there is
some possibility that the De Novo Dummy will simply
capture the effects ofparticular conditions in these states.
For example, intrastate bank competition already is very
vigorous in these three states, so that allowing interstate
entry may have very little procompetitive effect within the
home states, but may, through reciprocal provisions, add to
the ability of banks domiciled in these states to expand
elsewhere, thereby enhancing their potential profitability

Federal Reserve Bank of San Francisco

and, hence, their expected return. To the extent that this is
the case, the interaction of the De Novo Dummy with the
Change in Sta~es variable would be detecting effects akin
to the Rent Enhancing Model, and would be expected to
have a positive sign.
We also interact the Change in States variable with a
dummy variable indicating whether or nOLthe. state has
statewide branching.3D If the state has statewide branch~
ing, we. can expect the level of competition to be higher
than. if it has limited branching or unit banking. 31 This
would mean that the amount of excess profits that could be
competed away with new entry would be less, and, conse~
quently, that any drop in returns would be less. Thus, under
the Rent Depleting Model, the interaction of the Statewide
DUfiunywiththe Change inStates variable would have a
positive sign.
A.lternatively, under the Rent Enhancing Model, the
existence· of statewide branching, and, consequently,
larger banking organizations pre~interstate banking, may
mean fewer benefits to be had from scale or scope effects or
diversification effects. Thus, under the Rent Enhancing

Model, the interaction of the Statewide Dummy with the
Change in States variable would have a negative sign.
The remaining variable in Table I is entered to control
for general market conditions which may affect the realized return. The Market Return variable is intended to
capture the time serial influence of the general market on
bank stock returns. The coefficient on this variable can be
interpreted as the "beta" of the bank stocks in our sample.
Hence, it is expected that this variable would have a value
near positive 1.0.
As shown in Table 1, we do not include the Reciprocal
Dummy, the De Novo Dummy, nor the Statewide Dummy

in the regression by themselves. Thus, the specification of
the regression does not permit these variables to influence
the constant term. However, we did estimate a simplified
version of the regression with the dummy variables included by themselves, in addition to being included in
interaction terms. 32 The results of this regression were
consistent in all important respects with those of the main
regression that we report below. In general, the coefficients
on the dummy variables by themselves were insignificant,
and the other coefficients were either insignificant or had
the same sign as in the main regression.

IV. Regression Results
The results of the regression described above are reported in Table 2. 33 The coefficients from the full model
are presented, along with a Partial Model that employs
only the Change in States variable (along with the Market
Return variable). The sample mean of the dependent variable is .0357. The regression results reported in Table 2
were obtained using the effective dates of the laws to date
changes. The results using the passage dates were similar
and will be discussed below.
The results strongly support the notion that the long-run
effect of liberalized interstate banking is to enhance banking competition. We turn first to the Partial Model, which
contains only the Change in States variable. The coefficients on the various leads and lags suggest that the effect
of expansion in the number of source states has little effect
on returns three and two periods prior to the implementation date, but, starting in the immediately preceding
quarter, significantly depresses the affected banks' stock
returns. This finding is consistent with the Rent Depleting
Model of the effect of interstate banking.
Summing the coefficients on Change in States over the
seven periods in the distributed lag formulation indicates
the total effect, over time, of an increase in the number of
eligible source states. The sum of these coefficients is
strongly significant, and quite large. In effect, at the
sample mean, one additional source state reduces affected
banks' quarterly stock returns by about 3 percent for each
of seven quarters.
The "beta" of stock price returns to the market is very
close to one at .99 and is a significant contributor to the
variance of bank stock returns.
In the Partial Model, the only parameter describing the
law is the Change in States variable. In the Full Model, this
variable is interacted with dummies measuring three other
variations: reciprocal versus non-reciprocal (the Reciprocal Dummy), the case of allowed de novo entry versus
prohibited de novo entry (the De Novo Dummy), and
40

statewide branching versus restricted branching (the Statewide Dummy).
In the Full Model formulation, the coefficients on the
Change in States variable by itself capture the case of
a non-reciprocal, non-de novo law in a state with restricted branching. Consistent with the Rent Depleting
Model, all of these coefficients are negative and significant, and many are strongly significant. Consequently,
the sum of the various coefficients is negative and very
strongly significant. The evidence suggests that the market
reacts quite negatively to an increase in the numbei of
source states.
If the broadening of interstate banking occurs in the
context of a reciprocal law, however, the negative effects
of an increase in the number of regional source states are
not as strong. This is seen in Table 2, where all of the
Change in States X Reciprocal coefficients are positive,
and all but the third period lag coefficient are significant.
The sum also is positive and significant. These results are
consistent with the explanation given in the Rent Depleting
Model that reciprocity requirements effectively limit potential entry.
The coefficients on the variable interacting Change in
States and the De Novo Dummy are positive, yet insignficant, both individually and in their sum. It may be that a
de novo provision does not significantly influence the effect
of interstate banking laws, at least at the effective date.
(Below, we will discuss the effect of de novo provisions at
the passage date for the law.) On the other hand, as
discussed above, the banks of only three states dominate
the actual instances of banks in our sample in de novo
states. Therefore, we may not have enough data to accurately isolate the effects of the de novo provision from any
effects that may be particular to these three states.
Statewide branching appears to mitigate the negative
response to an increase in the number of source states. All

Economic Review / Spring 1991

of the significant coefficients on the Change in States X
Statewide variable are positive, and the sum is positive and
significant. These results are consistent with the prediction
of the Rent Depleting Model that statewide branching
leaves relatively little in the way of excess profits for
interstate banking to erode. 34
Both the Partial Model and the Full Model also were
estimated using the dates when the interstate banking laws
were passed instead of the dates when the laws went into

Federal Reserve Bank of San Francisco

effect. Throughout the following discussion, the reader
should keep in mind that we have relatively little confidence in the accuracy of our passage dates. This does not
mean that we do not know the dates when the laws were
passed by the state legislatures, but rather, that we do
not know the dates when the market began to assimilate
the information that interstate banking legislation would
be passed.
In most respects, the results obtained using the passage

dates were consistent with the results obtained with the
effective dates. In the Partial Model, all of the significant
coefficients on the Change in States variable (the coefficients on the first, second and third period lags) were
negative. However, although the sum of the distributed lag
coefficients was negative, it was insignificant.
Most important,though, all the Change in States coefficients were negative and significant, as was the sum, in the
Full Model with passage dates. In addition, the sum of the
coefficients on the Change in States X Reciprocal variable
was positive and significant, as before. The sum of the
Change in States X De Novo coefficients was positive, as
before,but, this time, significant. The sum of the Change
in States X Statewide coefficients was positive, as before,
but insignificant.
We have found that the market responds, in a qualitatively similar way, to both the passage and the implementation of interstate banking laws. This suggests not only that
the passage of suclllaws constitutes new information, but
that their implementation supplies significant additional
information, information which reinforces the original
response. This may be because, when the law is passed,
there is considerable uncertainty concerning the environment in which the law will become effective, whereas there
is no such uncertainty at the effective date.
In fact, our results suggest that, in some important ways,
the response of returns to the laws' implementation is
somewhat stronger than their response to the laws' passage,
subject to our dating of passage and enactment. For
example, in the Partial Model, the sum of the Change in
States coefficients is significant when using the effective
date but insignificant when using the passage date. In
addition, this sum is slightly larger in absolute value and
slightly more significant in the Full Model with the effective date (.027, with an absolute t-statistic of 13.73)
than in the Full Model with the passage date (.019, with an
absolute t-statistic of 12.31). Also, the branching status of
the state affects the response at the implementation date,
but not the response at the passage date.
Several factors might influence the absolute size and

significance of these coefficients. For example, the amount
of new information that is supplied to the market and the
significance of the information for current returns would be
important. The significance of a given amount of new
information will be less, the more distant in time is any
expected change in profits. This is because the present
discounted value of a given adjustment in future profits
will fall the farther off is the adjustment. This is. one
possible explanation for the relative size and significance
of the coefficients on Change in States in the two versions
of the Partial and Full Models.
An alternative explanation may be that we have a more
accurate dating forthe implementation than for the "passage" of the laws. The inability to pinpoint exactly when
new information on interstate banking laws might have first
appeared would contribute to the inefficiency of coefficient estimates in the passage date regressions. We have
some evidence that this may be the case. We estimated a
passage date regression with Change in States interacted
with the number of days until implementation of the law
included. 35 The capitalized value of future changes should
be lower the farther away is implementation, so this interaction term should be positive, given negative coefficients
on Change in States. We found that the interaction terms
were indeed positive, but insignificant. This lends some
support to the notion that we do not have an accurate
measure of the passage date.
Despite this concern, the significance of the positive
sum of the coefficients on Change in States X De Novo in
the passage date estimation of the Full Model deserves
some discussion. As mentioned above, it is likely that the
states that empirically have incorporated de novo features
may be those that already are highly competitive. Hence,
the effect in those states of expanded interstate banking is
more likely to be in the form of diversification advantages
to the home state banks as they are now able to enter all of
those states whose reciprocal banking laws permit such
entry. Apparently this effect shows up at the passage date,
and no additional significant effect shows up at the effective date.

Economic Review / Spring 1991

v. Conclusion
The empirical work in this paper suggests that interstate
banking, particularly when unrestricted by reciprocity requirements, tends significantly to enhance potential and/or
actual competition in state banking markets. 36 There is
little evidence to support the alternative hypothesis that
interstate banking results in significant cost savings due to
scale, scope, or diversification effects and/or consolidfltion
that yields less competitive banking conditions. Bank
holding company stock returns respond negatively and
significantly to an increase in the number of eligible source
states from which acquiring bank holding companies can
enter. This effect shows up at both the passage date and the
effective date of the interstate banking law, suggesting that
there is new information that comes to the market once the
law is actually implemented. In addition, the negative
effects are stronger in the absence of reciprocity requirements and weaker in the presence of a market that is
already relatively competitive, as indicated by statewide
branching provisions. 37
Conceivably, of course, the findings in this paper could
evolve in the long-run as interstate consolidation proceeds.
However, in the time frame of our data, the effects seem to
evolve in a direction consistent with more, rather than less,

Federal Reserve Bank of San Francisco

banking competitIon over time. In addition, although
depression of stock returns appears to be the overall effect
of increasing the number of source states, there do appear
to be conditions under which the returns of individual
banks in particular states may benefit from liberalizationof
interstate banking. Thus, the overall impacts have some
state-by-state variations, and stock analysts will have to
examine the particular circumstances of further liberalization of state banking laws to discern their effects on
individual bank stocks.
Finally, it is important to underscore the limitations of
the empirical work presented here. The sample ofbanks
studied here is not necessarily representative of the large
number of small banks in the nation. Thus, although it
seems that interstate banking increases competition among
medium- and large-sized banks, its specific effects on
small banks depends upon their competitive relationship
with the larger banks in their states. Also, our focus on
stock market returns, rather than the actual accounting
experience of individual banks, leaves open the possibility
that we have captured the market's expectations, but not the
reality, about the long-run effects of interstate banking.

NOTES
1. See Trigaux (1990).
2. Maine enacted the first interstate banking law, in 1975.
The law did not become effective, though, until 1978. It
was a number of years before interstate banking was
introduced in any other state; New York was the second,
passing a law that became effective in 1982.
3. Oregon is the only state that ever had a regional
nonreciprocal interstate banking law. In 1989, a national
nonreciprocal law went into effect in Oregon.
4. Some interstate banking laws contain additional provisions such as ceilings on out-of-state control of bank
deposits, minimum age requirem~nts for the ac.quir~e,
required commitments by the acqulrer to community reinvestment, or required capital-to-asset ratios for out-ofstate acquirers. Also, some laws prohibit "leapfrogging,"
the entry by a bank holding company headquar.te.red
outside the eligible region, with only a toe-hold subsidiary
in a state in the region.
5. As of 1989, Kansas, Montana, and North Dakota had no
interstate banking laws, so they are excluded from the
chart.
6. In Chart 1, the number of states in the eligible region
corresponds to the number of potential states, whether
or not those states have in fact met the reciprocity requirement.
7. See Zuckerman (1990) for a discussion of Utah's new
interstate branching law. Nevada's law is somewhat restrictive in that it allows out-of-state banks to set up de
novo branches only in counties with a population below
100,000. It is unclear whether the law will be interpreted
to allow acquisition or merger with existing branches.
(Source: Conversation with the office of the Commissioner, Financial Institutions Division, Nevada Department
of Commerce.)
8. Whether a bank would choose to diversify so as to
reduce risk would depend on a number of factors, including the risk preferences of shareholders, the risk preferences of bank managers, and the opportunities for
shareholders to efficiently diversify their asset portfolios in
the securities market. Bank managers' risk preferences
are likely to be affected by the nature of bankruptcy costs
and the existing system of deposit insurance. (See Boyd
and Graham (1986) and Santomero (1984) for further
explication of these issues.)
9. For example, regulators impose a barrier to entry by
requiring experience in banking as a prerequisite for a
new bank charter.
10. See, for example, Keeley and Zimmerman (1985).
11. A market model specifies a particular company's
stock returns to be a function of returns on a well-diversified portfolio of stocks and, perhaps, of other f~ctors
correlated with aspects of systematic or nondlverslflable
risk such as interest rates. In an "event studY," such
as that used by Born, Eisenbeis and Harris, the effects of

the events on stock returns are isolated by comparing returns around the time of the event with the returns predicted by the market model. The difference is labelled
"abnormal returns" and is attributed to the effect of the
event under study.
12. See, for example, Jensen and Ruback (1983). The
Born Eisenbeis and Harris finding also is qualitatively
consistent with the finding in de Cossio, Trifts and Scanlon
(1987). These authors find that bidding firms in bank
acquisitions receive significantly higher abnormal returns
when they are involved in intrastate as opposed to Interstate mergers, while target firms earn significant abnormal
returns from both intrastate and interstate mergers.
13. Similarly, Rose and Wolken (1990) foun~ that, in unit
banking. and limited branching state~, afflliatl~n :-'lIth a
bank holding company generally proVides no Significant
long-term competitive advantage (in terms of .market
share accumulation) for holding company subsldlanes
over independent banks.
14. Liang and Rhoades calculate the probability of bank
insolvency to be a function of the expected net-income-toasset ratio, the capital-to-asset ratio, and the standard
deviation of net income-to-assets.
15. The "premium" in a merger is the difference between
the price per share of stock paid by the acquirer ~~d the
price per share just prior to the time thatthe pOSSibility of a
merger first became known to the publiC, In some cases,
the premium is fully capitalized in the market pnce of the
stock and the acquirer pays a price per share corre-

sponding to the market price. In othe~ cases, the acquirer
ends up paying more than the prevailing market pnce per
share. Adkisson and Fraser proxy the base market value
of the firm with the book value of the firm, and measure the
premium as the ratio of the purchase price to the book
value.
16. Despite the evidence cited suggesting the relative
unimportance of economies of scale and scope, one
might still reasonably maintain that such ef.fects are Indeed important. There are two potentially mitigating factors that bank cost studies may not adequately take Into
account. First, the FDIC's "too big to fail" policy undoubtedly favors large banks over small ones, and this may
have the effect of decreasing large banks' cost of funds.
Second, banks with large branch networks may be preferable, for reasons of convenience, from the bank customer's point of view. This may be true even though, for a
given level of services, such banks may produce services
no more efficiently than small banks.
17. As of December 31,1985, there were 15,072 commercial banks in the United States, (Source: Annual Statistical
Digest.)
18. A previous researcher, Chong (1989), has studied
the effects of the passage of interstate banking laws on
bank holding company stock returns. He estimated a twofactor market model, regressing individual daily bank

Economic Review / Spring 1991

stock returns on a constant term, the market return, the
twist of the yield curve, and interstate banking law announcement date dummies, interacted with all the other
independent variables. Chong's inclusion of the market
return and yield curve interaction terms in his regression
seems somewhat arbitrary. It is unclear why, in theory,
interstate banking would affect a bank's exposure to
systematic risk at all. Chong finds that interstate banking
increases banks' profitability and their exposure to market
risk, but not interest rate risk.
Our model differs from Chong's in three respects. First,
we look for effects in quarterly stock returns, not daily
returns. A day seems too short a time frame in which to
detect the effects of changes in laws. Second, we look at
the response of returns around the date when the law
goes into effect, as well as around the date when it is
passed. Third, our specification differs in that we do not
allow interstate banking to affect exposure to systematic
risk, but we do, unlike Chong, allow different types of laws
to have different effects. In addition, we allow the laws to
have different effects in different environments. Because
our model is significantly different from Chong's model,
we do not expect that our results should accord with his.
19. We employed three leads, a contemporaneous term,
and three lags in the specification of the model. Since our
observations are quarterly, this structure allows for a
relatively long period over which interstate banking law
changes can affect bank stock returns. Such a large
window is unusual in a traditional "event study." However,
such studies usually examine the effects of events, such
as merger announcements, that are hypothesized to have
relatively certain consequences at certain times for certain banks. In contrast, our study examines the effect of an
event whose effects, even in theory, are not as welldefined in these respects. Therefore, it seems to us reasonable to assume, a priori, that the effects will be spread
out over a relatively long period of time.
20. The estimation of a polynomial distributed lag (PDL)
formulation spares degrees of freedom by introducing a
specific structure to the various lag coefficients. For example, using a third-degree PDL to estimate the coefficients in a ten-lag model reduces the number of estimated
parameters from ten to four. The ten coefficients, wo, W1,
. . . , Wg are replaced by the formula
Wi = Co + c 1i + C2i2 + C3i3
i = 0, 1, 2, ... 9
where the cs are the four parameters of the polynomial to
be estimated.
21. One technique is to introduce dummy variables for
every cross-sectional observation and time period. Entered in the regression by themselves, they permit the
intercept term, a, to vary across banks and over time. Additionally, cross-sectional dummies can be interacted with
the explanatory variables, permitting the slope coefficients, b, C, and d, to vary cross-sectionally. We were able
to examine time variation in the intercept, but, due to
software limitations, we were not able to examine any
variation in the slopes.
Alternatively, an error-components model can be esti-

Federal Reserve Bank ofSan Francisco

mated directly, permitting the error term eit to be decomposed into cross-section specific, time-series specific,
and mixed effects. This technique involves a generalized
least squares estimation technique that is foreclosed
by computation limitations and the necessity to include
le;tggedexplanatqry variables.
22. ThE:). criteria for inclusion in the Compustat bank file
are that the company's stock be actively traded and that
the company has high investor interest. Deletions are
effected upon mergers, suspensions from trading, and
bankruptcy filings.
23. We have bank holding companies in 44 different
states in our sample. Our sample does not contain any
bank holding companies located in Montana, North Dakota., South Dakota, Maine, New Hampshire, Vermont or
Kansas, but does contain at least one bank holding company located in Washington, D.C., which is treated as a
S$parate"state.',
24. We also classified the laws according to their geographic focus (Regional versus National). However, the
effect of this distinction proved to be statistically insignificant, so we omit it from the reported regression results.
Because we also included the change in the number of
eligible source states as an explanatory variable in the
regression, it is not surprising that the national versus
regional distinction was insignificant.
25 .. In 1983, 19 of the 44 states represented in our sample
had statewide branching.
26. There are 186 observations in our sample with nonzero values of Change in States.
27. It may be argued that, just as anticipated diversification benefits may cause an increase in the stock price of
potential acquirers and/or acquirees, so may anticipated
competitive benefits. The anticipated increase in profits
due to entry into markets where competition had been
lying dormant may increase the stock price of potential
merger participants. However, we expect that the negative effects felt by those banks facing increased competition but not anticipated to be involved in mergers would
outweigh any positive effects felt by potential merger
candidates. On the other hand, we do not expect anticipated diversification to have any effect, by itself, on those
be;toks that are not jUdged by the market to be potential
merger candidates. Therefore, for the market as a whole,
diversification should increase stock prices.
28. There are 174 observations in our sample with nonzero values of Change in States X Reciprocal.
29. There are 51 observations in our sample with non-zero
values of Change in States X De Novo.
30. There are 76 observations in our sample with nonzero values of Change in States X Statewide.
31. Studies have shown that barriers to entry in the form
of branching restrictions decrease competition in local
banking markets. For a review of these types of studies,
see McCall (1980).
32. As in the main regression, three leads, a contemporaneous term, and three lags were included.

33. The number of observations is the original number of
observations in the sample, 10,868, minus any observationsdeleted owing to the lag structure ofthe model.
34. To test further the hypothesis that a relatively competitive banking market sees less of a negative impact
from interstate banking, we also estimated the full model
with a four-firm concentration ratio variable added. Like
the dummy variables, this variable entered in interaction
terms with the Change in States variables. The estimated
coefficients on these interaction terms were insignificant,
and the signs and. significance .of the othercoe.fficients
were· unaffected.
Theooncentration ratio does not perform as well as
the statewide branching variable. This may be because,
even though, on a statewide pasis,. markets in restricted
branching states are not highly concentrated, local market power may be substantial.
35. Both these regressions and the original Full Model
regression with passage dates were complicated by the
existence. of legislation which specifies a regional law
with a national trigger date. In such instances, both future changes were passed on the same date. Thus, there
are two potential values for Change in States when using
the passage date: the number of states that is to be
included in the region, and the number of states that is to
be added at the time when national interstate banking
goes into effect.
In the original Full Model, we chose 50 for Change in
States in instances when a regional law with a national
trigger date was passed. In the model including the
interaction terms involving the number of dates from passage to implementation, we defined two Change in States
variables, as described above.
36. In a study of the effect of competition on bank charter
values and risk-taking, Keeley (1990) found that liberalized interstate banking does not affect the level of
competition. We do not believe that his result is directly
comparable to our result, since he does not allow for
different effects depending upon the type of law and the
number of states that can enter.
37. In a recent paper, Black, Fields and Schweitzer (BFS)
(1990) find results that are not entirely consistent with ours.
They find that the passage of interstate banking laws
increased the stock returns of regional banking organi-

zations and decreased the stock returns of money center banks.
The authors attribute their results to the differential
treatment of source states with and without money center
banks. Initially, many interstate banking laws prohibited
entry from states in which money center banks are headquartered. This means that, all other things equal, money
centerbanks faced fewer instances in which their own
states' passage of legislation enabled them, through reciprocity agreements, to enter other states. Thus, the authors seem to argue, the main effect of interstate banking
legislation in states with money center banks is to lower
stock returns through an increase in potential competition.
In regional bank states, they seem to suggest, this negative rent depleting effect is more than offset by the
positive effect of an increase in thenumber of target states
(through reciprocity agreements).
We estimated regressions that controlled for bank size,
and we did not find this to be a significant determinant
of the qualitative effect of interstate banking legislation.
Because money center and regional banks can likely be
effectively distinguished by size, our results likely disagree with the BFS results; we seem to find a negative effect on stock returns for both money center and
regional banks.
At least two explanations can be given for the difference
in results. First, our evidence shows that it is important to
look at both the passage and the effective dates, and to
look at a relatively large window on either side of the event
dates. (The BFS study uses a window beginning 30 days
prior to passage and ending 30 days after passage.)
Indeed, we too find positive (but individually insignificant)
coefficients for the third, second, and first period leads in
our Partial Model with passage dates, but the sum of lead,
contemporaneous and lag coefficients is negative.
Second, the BFS control variable is based on bank
stock returns in states that did not concurrently pass their
own legislation. It is unclear to what degree the passage
dates in the BFS data set coincide. If there is significant
coincidence, the BFS methodology presents a potentially
serious endogeneity problem. This is because the timing
of interstate banking legislation in various states may be
dependent on factors such as the condition of banks and
the competitive environment in those states. These factors
may also independently influence differences between
bank stock returns, thereby biasing regression results.

Economic Review / Spring 1991

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Full text of Economic Review (Federal Reserve Bank of San Francisco) : Spring 1991, Number 2

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