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FINANCIAL INDUSTRY
December 1 9 9 2

Federal Reserve Bank of Dallas

The Movement Toward
Nationwide Banking:
Assessing the Role
of Regional Banking

Difficulties

Jeffery W. Gunther
Senior Economist

The Role of Bank Capital
in Bank Loan Growth:
Can the Market Tell Us Anything
that Accountants
Don't?
Robert R. Moore
Senior Economist

1989
1990
1991
This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org)1992

Financial Industry Studies
Federal Reserve Bank of Dallas
December 1992

President and Chief Executive Officer
Robert D. McTeer, Jr.
First Vice President and Chief Operating Officer
Tony J. Salvaggio
Senior Vice President
Robert D. Hankins
Vice President
Genie D. Short
Senior Economists
Jeffery W. Gunther
Robert R. Moore
Kenneth J. Robinson
Economist
Linda M. Hooks
Financial Analyst
Kelly Klemme

Industry Studies is published by the Federal Reserve Bank
of Dallas. The views expressed are those of the authors and
do not necessarily reflect the position of the Federal Reserve Bank
of Dallas or the Federal Reserve System.

Financial

Subscriptions are available free of charge.
Please send requests for single-copy and multiple-copy subscriptions,
back issues, and address changes to the Public Affairs Department,
Federal Reserve Bank of Dallas, Station K, Dallas, Texas 75222, (214) 922-5254.
Articles may be reprinted on the condition that the source
is credited and the Financial Industry Studies Department is provided
a copy of the publication containing the reprinted material.

The Movement Toward
Nationwide Banking:
Assessing the Role of Regional
Banking Difficulties
Jeffery W. Gunther
Senior Economist
Financial Industry Studies Department
Federal Reserve Bank of Dallas

arge numbers of relatively small, local
banking organizations distinguish the
U.S. financial system from the majority of
systems found in other countries, reflecting, in part, a long history of geographic
restrictions in this country. These restrictions resulted from fears that large financial
institutions might develop excessive power
and become unresponsive to the needs of
local businesses, small banks' desire to
restrict competition from larger institutions,
and numerous other forces.
A key component of the geographic
restrictions placed on full-service banking
involved limitations on the ability of institutions to cross state lines. The McFadden
Act, as amended in 1933, restricted the
branching rights of national banks in a
given state to those established by the state's
authorities for state-chartered banks. This
legislation effectively precluded national
banks from branching across state lines.
The Douglas Amendment to the Bank Holding Company Act of 1956 further restricted
interstate expansion by barring bank holding companies from acquiring a bank in
another state unless that state specifically
authorized the transaction.
Until recently, states made little use of
their authority to allow interstate banking
through holding company transactions. But
that situation changed dramatically during
the 1980s, and a recent compilation of interstate banking laws found that all but two

states permit some form of interstate banking. Even so, the nature of the interstate
banking laws recently enacted varies considerably from state to state, from fairly
restrictive regional banking pacts to relatively open laws allowing entry of bank
holding companies from any state.
Numerous developments played a role
in the recent trend of falling barriers to
interstate banking.1 But perhaps one of the
most powerful precipitating forces was the
emergence of regional financial-sector
difficulties that gave rise to imbalances in
bank capital between states.
The purpose of this article is to provide
new evidence on the importance of regional
banking difficulties in motivating an increasing number of states to adopt relatively
unrestrictive interstate banking laws. The
findings suggest that regional banking difficulties did serve to undermine the system
of interstate banking restrictions, as states
with depleted bank capital levels opened
their borders to out-of-state banking organizations in an effort to strengthen their
weakened banking sectors. By inhibiting
geographic diversification among banks,
interstate banking restrictions arguably contributed to the severity of recent regional
banking downturns, thereby setting the
stage for their own demise.

Regional Banking Difficulties
as a Motive for Interstate Banking
Bernanke and Gertler (1987) demonstrate how, under certain conditions, the
financial health of the banking sector can
affect the allocation of resources and the
level of economic activity. In their view, an
adverse shock to the banking sector reduces
lending capacity, since bank depositors
concerned over the safety of their deposits

1 See Rose (1989) for a detailed account of the recent
development of interstate banking and a description
of its motivating forces. Also, see Clair and Tucker
(1989) for a historical account of Federal Reserve
policy toward interstate banking.

require banks to reduce the quantity of
loans extended to fund risky ventures and
to place a larger share of bank assets in
relatively safe investments.2 The resulting
reduction in lending activity has the potential to produce a "credit crunch," in which
the decrease in bank lending restricts economic growth.
Samolyk (1989) extends this line of
thought by considering the potential impact
of adverse shocks to a regional banking
sector on regional economic activity. To the
extent that the banking system is segmented
into distinct regional banking sectors, an
adverse shock to the banking sector in a
given region could generate a corresponding reduction in regional lending activity,
as stronger banks in surrounding regions
would be unable to help maintain lending
levels in the affected area. The resulting
reduction in regional lending activity would
then have the potential to restrict regional
economic growth.
Insofar as interstate banking restrictions
were perceived as a major factor contributing to a regional segmentation of the country's banking system, state lawmakers may
have viewed the removal of those restrictions as a viable method for avoiding a
perceived regional credit crunch. Disagreement exists among previous studies regarding the extent to which regional banking
difficulties actually did contribute to regional
economic downturns.3 However, for purposes of the argument developed here, it is

This framework must he altered somewhat to address
the current banking environment, in which the federal
government guarantees, explicitly or implicitly, a large
proportion of bank deposits. When the safety of bank
deposits is guaranteed, as under federal deposit insurance, then the government assumes the monitoring
and disciplining role that otherwise would be provided by depositors.
2

See Moore (1992) and the references cited there.

See Gunther (1992) for a discussion of the incentives bank owners may have either to support or
oppose the removal of interstate banking restrictions.

necessary only that state lawmakers perceived that downturns in regional banking
conditions could adversely affect regional
economic performance. To the extent that
this occurred, states with banking difficulties may have adopted relatively unrestrictive interstate banking laws in an effort to
promote adequate lending services for
local businesses.
In addition, state lawmakers may have
viewed the removal of interstate banking
restrictions as an appropriate response to
regional banking difficulties, even if those
difficulties were not seen as having a potentially adverse impact on regional economic
growth. In particular, the removal of interstate banking restrictions simply may have
been viewed as a necessary step for the
revitalization of the banking sector itself.4
By allowing out-of-state bank holding
companies to acquire local banking firms,
unrestrictive interstate banking laws may
have provided states with an effective
mechanism for attracting new bank capital.
The central idea under investigation here is
that such considerations actually played an
important role in motivating an increasing
number of states to open their borders to
relatively unrestricted interstate banking.

Regional Distribution of Interstate
Banking Laws
Three categories of interstate banking
law. The laws recently enacted to allow
interstate banking vary considerably from
state to state. Different states have chosen
to retain different restrictions with regard to
a number of factors, including, but not
limited to, the range of states from which
bank holding companies are allowed to
acquire banks in the home state, whether
bank holding companies headquartered in
the home state must be allowed to acquire
banks located in the state in which an
acquiring bank holding company is headquartered, whether de novo entry of out-ofstate bank holding companies is permitted,
and the minimum allowable age of banks
acquired by out-of-state organizations.

Chart 1
Interstate Banking Laws

I No Provisions
National Reciprocal

•

Regional Reciprocal

National Without Reciprocity

S O U R C E : A m e l (1991).

For purposes of the analysis here, it is
convenient to abstract from some of these
details and to rank the openness of the
various interstate banking statutes on the
basis of two primary factors: 1) whether
the law permits bank holding companies
headquartered in any state to acquire banks
in the home state or, instead, limits entry
only to bank holding companies headquartered in specific states, and 2) whether the
law requires that bank holding companies
headquartered in the home state must be
allowed to acquire banks in the states in
which acquiring bank holding companies
are headquartered; that is, whether the law
requires reciprocity.
On the basis of these two factors, the
various interstate banking laws can be
divided into the following three major categories: 1) regional reciprocal laws, under
which only bank holding companies head-

quartered in a certain group of states are
permitted to acquire banks in the home
state and reciprocity is required, 2) national
reciprocal laws, under which bank holding
companies headquartered in any state are
allowed to acquire banks in the home state
and reciprocity is required, and 3) national
laws without the reciprocity requirement,
under which bank holding companies in any
state are allowed to acquire banks in the
home state and reciprocity is not required.
Note that these categories form a hierarchy,
with regional reciprocal laws constituting
the most restrictive type of interstate banking law and national laws without the reciprocity requirement constituting the most
open type of law.
Recently adopted interstate banking
laws. Chart 1 shows the type of interstate
banking law most recently adopted by
each state, as documented in Amel (1991).
3

Only two states, Hawaii and Montana,
have not provided for one of the three
forms of interstate banking defined above. 5
Among the remaining states, the national,
national reciprocal, and regional reciprocal
forms of interstate banking laws are each
widely used.
A significant number of states have
adopted national interstate banking laws
without reciprocity requirements. Thirteen
states, along with the District of Columbia,
allow bank holding companies headquartered in any state to acquire banks within
their borders and do not require reciprocity. As shown in Chart 1, ten of these states
are located in a band stretching northwestward from Texas and Oklahoma through
Oregon and Idaho. Maine, New Hampshire,
and Alaska also have adopted national
interstate banking laws without the reciprocity requirement.
The majority of states using national
reciprocal laws are concentrated in a band
stretching southwestward from New England
through Illinois, Kentucky, and Tennessee.
North Dakota, South Dakota, and Nebraska
also have adopted this form of law. In all,
twenty-one states allow bank holding companies headquartered in any state to acquire
banks within their borders as long as similar
privileges are granted to their bank holding companies.
Regional reciprocal laws are prevalent in
the Southeast, South Atlantic region, and
throughout a band stretching northward
from Arkansas through Wisconsin and Minnesota. Fourteen states permit only bank
holding companies headquartered in certain
other reciprocating states to acquire banks
within their borders.

In the case of Hawaii, banks may be acquired by
bank holding companies headquartered in American
Samoa, Guam, the Marshall Islands, Micronesia, the
Northern Marianas, and Palau. Only failing banks may
be acquired by bank holding companies headquartered in other states. Montana has not provided for
interstate banking of any form.
5

Regional Differences
in Banking-Sector Strength
The diversity in the interstate banking
laws adopted by the various states is
matched by the variability in regional banking conditions that occurred during the
past ten years. Chart 2 shows the minimum
year-end adjusted capital ratio that occurred
for each state's banking sector during the
1982-91 period. The adjusted capital ratio
is defined as the difference between the
following two components: 1) the equity
capital ratio, which is the ratio of equity
capital to gross assets, and 2) the adjusted
troubled asset ratio, which is the ratio of
other real estate owned, nonaccrual loans,
and loans past due 90 days or more to gross
assets minus the ratio of loan loss reserves
to gross assets. A negative value for the
adjusted troubled asset ratio would indicate
that a state's banking sector had more loan
loss reserves than troubled assets. As a
measure of banking-sector strength, the
adjusted capital ratio attempts to incorporate both the potential for losses, as indicated by the level of foreclosed real estate
and noncurrent loans, and the capacity to
absorb losses, as indicated by the level of
equity capital and loan loss reserves.
As shown in Chart 2, thirteen states
maintained adjusted bank capital ratios
above 6 percent, and the adjusted capital
ratio remained above 5 percent in an additional nine states. Many of the states in these
two relatively strong groups are located in
the Southeast, South Atlantic region, Midwest, and Great Lakes region.
In contrast to the relatively strong performance of states in the first two groups,
many other states experienced sharp regional
recessions and correspondingly adverse
banking conditions. The minimum adjusted
capital ratio fell between 3 percent and 5
percent in 17 states and dropped below 3
percent in an additional eleven states and
the District of Columbia. Many of the
hardest hit states are located in the West,
Southwest, and Northeast.
The regional diversity in both banking-

Chart 2
Adjusted Capital Ratio for State Banking Sectors, Minimum for the Period 1982-91

I Over 6 percent

•

5 to 6 percent

3 to 5 percent

•

Under 3 percent

SOURCE: Report of Condition and Income.

sector health and the openness of interstate
banking laws leads to the possibility that
the two phenomena are related. And a
casual comparison of Charts 1 and 2 hints
at such a linkage, as the shading of the two
charts follows a somewhat similar regional
pattern. A correspondence between regional
banking difficulties and the openness of
state statutes pertaining to interstate banking would support the idea that regional
capital imbalances contributed to the recent
relaxation of the longstanding geographic
restrictions placed on banking organizations.

Banking-Sector Strength and the Choice
of Interstate Banking Law
The case of Texas. The importance of
regional bank capital shortages in precipitating the removal of interstate banking

restrictions has been especially clear in certain cases. In particular, within the Eleventh
District, the removal of interstate banking
restrictions in Texas can be traced to the
need to attract new bank capital in the aftermath of the state's severe banking downturn.
Chart 3 compares the adjusted capital
ratio for Texas banks with the average ratio
for all states. The Texas capital ratio fell
sharply during the 1986-87 period, as the
state's energy and real estate sectors led the
regional economy into a severe recession.
National interstate banking, with no reciprocity requirement, became effective in
January 1987, as the state attempted to attract
the capital needed to resolve its banking
difficulties. While the timing of this legislation suggests that a regional capital shortage
was an important determinant of the movement to unrestricted interstate banking in
5

Chart 3
Adjusted Capital Ratio for State Banking
Sectors, Texas Versus National Average
Percent

SOURCE: Report of Condition and Income.

Texas, the importance of regional hanking
difficulties generally in contributing to the
removal of interstate banking restrictions
remains to be seen.
Cases of national interstate banking
without reciprocity. Chart 4 shows the
equity capital ratio and the adjusted troubled
asset ratio for each state at the beginning
of the year in which the state's most recent
type of interstate banking law became
effective.6 Because the states are identified
by the type of interstate banking law they
adopted, Chart 4 can be used to form a
rough assessment of the strength of any
association between regional banking-sector
strength and the various forms of interstate
banking law. States located in the upper left
quadrant of Chart 4 had relatively strong
banking sectors when they implemented
their interstate banking statutes, as evidenced
by both high capital ratios and low adjusted

troubled asset ratios. Conversely, states
located in the lower right quadrant had
relatively weak banking sectors, as indicated
by both low capital ratios and high adjusted
troubled asset ratios. Location in the lower
left quadrant indicates a relatively low
adjusted troubled asset ratio, but also a relatively low equity capital ratio. The upper
right quadrant corresponds to relatively
high equity capital ratios and also relatively
high adjusted troubled asset ratios.
Chart 4 points to a positive relationship
between financial difficulty in state banking
sectors and the openness of state laws
pertaining to interstate banking, thereby
supporting the idea that regional imbalances
in banking conditions contributed to the
removal of interstate banking restrictions.
Of the fourteen instances of the most open
form of interstate banking law—national
interstate banking without the reciprocity
requirement—none fall into the upper left
quadrant, which is associated with bankingsector strength. In contrast, 43 percent of
the states with national reciprocal laws and
50 percent of the states with regional recip-

Chart 4
Equity Capital Ratio and Adjusted Troubled
Asset Ratio by Type of Interstate Banking Law
Equity capital ratio (Percent)

+ *

• '
ft

ft
•

ft
+

+
+

1
For the few states that adopted their most recent
type of interstate banking law in 1982, data availability
constraints necessitated measuring the ratios on an
end-of-year rather than beginning-of-year basis.

Adjusted troubled asset ratio (Percent)

•

Regional Reciprocal

National Reciprocal

National

SOURCE: Amel (1991); Report of Condition and Income.

rocal laws are located in that quadrant.
Moreover, only 24 percent of the states
with national reciprocal laws and 7 percent
of the states with regional reciprocal laws
fall into either the upper-right or lowerright quadrants, both of which correspond
to relatively high levels of troubled assets.
In contrast, 57 percent of the instances of
national interstate banking without reciprocity are located in those two quadrants.
These figures are consistent with the
view that the emergence of regional banking difficulties helped motivate the removal
of interstate banking restrictions through
the adoption of national interstate banking
laws with no reciprocity requirement. However, while Chart 4 offers a detailed view
of the data on banking-sector strength for
individual states, its usefulness in terms of
drawing inferences on the relationship
between regional banking difficulties and
the choice of interstate banking law is somewhat limited. In particular, the proportion
of states in each of the four quadrants
depends partially on the positioning of the
lines that separate the quadrants. A simple
method of overcoming this potential drawback is to calculate the average capital and
adjusted troubled asset ratios for states
adopting each type of interstate banking law.
Comparisons can then be made between
the average level of banking-sector strength
associated with each type of law.
An analysis of the average equity capital
ratio and the average adjusted troubled
asset ratio for each of the three types of
interstate banking law also points to a positive relationship between banking-sector
difficulties and the openness of interstate
banking statutes. Chart 5 shows the average
equity capital ratio and the average adjusted
troubled asset ratio that prevailed in states
choosing each type of interstate banking
law.- The figures shown are consistent with
the view that states with unrestrictive laws
allowing for national interstate banking
without reciprocity tended to have lower
equity capital ratios when they implemented
their interstate banking statutes than states
that allowed only regional interstate bank-

Chart 5
Equity Capital Ratio and Adjusted
Troubled Asset Ratio, Average
by Type of Interstate Banking Law
Equity capital (Percent)

Troubled assets (Percent)

7.1-1

r1.6

Regional
Reciprocity
I

Equity Capital Ratio

National
Reciprocity
^

National
without Reciprocity

Adjusted Troubled Asset Ratio

SOURCE: Amel (1991); Report of Condition and Income.

ing. In addition, Chart 5 suggests that states
choosing national interstate banking without the reciprocity requirement tended to
have higher adjusted troubled asset ratios
than both states that allowed only regional
interstate banking and states that permitted
national interstate banking but required
reciprocity.8
These results also are consistent with the
view that regional banking difficulties were
an important force behind the adoption of
state laws permitting national interstate
banking without reciprocity. It should be

The figures portrayed in Chart 5 are averages, by

type of interstate banking law, of the figures for
individual states given in Chart 4.
While the differences in the ratios across types of
interstate banking law may appear small, their economic significance can be considerable. Because
banks tend to operate with fairly low capital ratios,
even a relatively small adverse change in either the
capital ratio or the adjusted troubled asset ratio can
represent a substantial increase in financial difficulty
and necessitate strong corrective action.

noted, though, that a variety of statistical
considerations preclude using Charts 4 and
5 by themselves to form statistically reliable
assessments of the association between the
choice of interstate banking law and either
the capital ratio or the adjusted troubled
asset ratio. However, the conclusions
reached here regarding the relationship
between regional banking difficulties and
the removal of interstate banking restrictions
receive additional support of a more formal
nature in Gunther (1992), where a statistical
technique known as probit analysis is used
to identify the determinants of the adoption
of interstate banking without reciprocity.
The statistical results reported there are
qualitatively identical to the findings based
on Charts 4 and 5.9 In summary, a considerable amount of evidence exists that regional
banking downturns played a major role in
motivating the increased use of relatively
unrestrictive interstate banking laws.

Concluding Remarks
The geographic restrictions historically
applied to full-service banking in this

For example, the statistical estimates reported there
suggest that, for a representative state, a 50 basispoint reduction in the equity capital ratio, together
with a similar increase in the adjusted troubled asset
ratio, increases the probability of adopting national
interstate banking without reciprocity from 15 percent
to 37 percent.
9

10 It should be emphasized, however, that geographic
restrictions alone cannot totally explain recent financialsector difficulties, as evidenced by the financial problems that occurred among very large banks possessing
substantial diversification possibilities.

country arguably contributed to the numerous regional banking downturns that have
occurred in recent years. By reducing the
ability of banking organizations to spread
their operations across diverse regional
economies, geographic restrictions increased
the vulnerability of bank net earnings to
adverse region-specific economic shocks.10
The resulting frequency and severity of
recent regional banking difficulties then
served to undermine the system of geographic restrictions. Regional imbalances in
banking-sector strength led states seeking
new capital to remove geographic restrictions through the adoption of relatively
unrestrictive interstate banking laws.
The breakdown of interstate banking
restrictions provides a clear example of a
regulation that self-destructed. In this respect,
interstate banking restrictions are similar to
a variety of other artificial constraints, including interest rate ceilings and various
product-line restrictions, that recently were
lifted from U.S. financial institutions only
after they had caused substantial harm.

References
Amel, Dean F. (1991), "State Laws Affecting
Commercial Bank Branching, Multibank
Holding Company Expansion, and Interstate Banking," unpublished manuscript,
Board of Governors of the Federal Reserve
System, May.
Bernanke, Ben S., and Mark Gertler (1987),
"Banking and Macroeconomic Equilibrium,"
in New Approaches to Monetary
Economics,
ed. William A. Barnett and Kenneth J. Singleton (New York: Cambridge University
Press), 89-111.
Clair, Robert T., and Paula K. Tucker (1989),
"Interstate Banking and the Federal Reserve:
A Historical Perspective," Federal Reserve
Bank of Dallas Economic Review, November, 1-20.

Studies Working Paper 5-92, Federal
Reserve Bank of Dallas (Dallas, December).
Moore, Robert R. (1992), "The Role of Bank
Capital in Bank Loan Growth: Can the
Market Tell Us Anything that Accountants
Don't?" Federal Reserve Bank of Dallas
Financial Industry Studies, this issue.
Rose, PeterS. (1989), The Interstate Banking Revolution: Benefits, Risks, and Tradeo f f s for Bankers and Consumers (Westport,
Conn.: Quorum Books, Greenwood Press,
Inc.).
Samolyk, Katherine A. (1989), "The Role of
Banks in Influencing Regional Flows of
Funds," Federal Reserve Bank of Cleveland, Working Paper 8914 (Cleveland,
November).

Gunther, Jeffery W. (1992), "Regional Capital
Imbalances and the Removal of Interstate
Banking Restrictions," Financial Industry

Acknowledgment
The author would like to thank, without
implicating, Dean F. Amel for helpful
discussions.

The Role of Bank
Capital in Bank
Loan Growth:
Can the Market Tell Us Anything
that Accountants Don V
Robert R. Moore
Senior Economist
Financial Industry Studies Department
Federal Reserve Bank of Dallas

ecent sluggishness in bank lending has
led to concern that a lack of bank
credit may be dampening economic activity.
A number of analysts have focused on the
importance of bank credit recently by
examining the role of banks in contributing
to a "credit crunch," in which a lack of
credit to creditworthy borrowers reduces
real economic activity.1 While the formal
evidence on the existence of a credit crunch
is mixed, anecdotal reports of a credit
crunch were common during 1991, and
thus I focus on lending during that year.
Regardless of whether a credit crunch
existed during my sample period, there was
a great deal of variability in loan growth
across bank holding companies. While total
lending by the holding companies in my
sample declined slightly, loan growth ranged
from sharp contraction to strong expansion
at individual holding companies. Hence, if
there was a credit crunch, the effects were
more severe among borrowers at some banks
than at others, and if there was not a credit
crunch, credit availability may nevertheless
have been restricted for some borrowers.
Therefore, in addition to the difficulties
caused by a low level of loan growth in a
credit crunch, the variability of loan growth
may cause additional problems.
Given the potential effects of the variability in loan growth, I wish to explain the

cause of differences in loan growth across
bank holding companies. To accomplish
this, I examine the effects of bank holding
company capital on loan growth. Bank
capital is important because it may constrain
banks' lending, thereby contributing to
loan growth variability and possibly leading
to a credit crunch. The influence of capital
on lending may occur through its influence
on the relationship between the bank and
its depositors2 or through its influence on
the regulatory treatment of banks.
Other analysts have considered the role
of bank financial condition on bank lending.3 These studies primarily have considered
capital as measured by a bank's book value.
A bank's book value, however, may be an
inaccurate measure of the "true" value of
capital. One reason for this is that bank
assets are often recorded at their historical
cost and are not adjusted for fluctuations in
their value.
In an effort to measure more accurately
the value of a bank holding company, this
study considers not only a bank holding
company's book value but also its market
value. Introducing a measure of the market
value of capital is desirable because accounting measures of capital may inaccurately
measure the "true" value of capital. If the
market value of capital reflects additional
information about the "true" value, then
including the market value should lead to
improved measurement of the importance
of capital in the lending process.
I find that both the market and book
measures of capital help explain variation
in loan growth across holding companies,
with a positive relationship between both

1 Bernanke and Lown (1991), Gunther, Lown, and
Robinson (1991), and Samolyk (1991) investigate
"credit crunches."

See Bernanke and Gertler (1987).

Bernanke and Lown (1991), Clair and Yeats (1991),
and Peek and Rosengren (1991) consider the effect of
bank capital on bank lending.

capital measures and loan growth. This
suggests that the market value of capital
contains information about the "true" value
of capital that is not included in accounting
measures.

Determinants of Lending
There are many determinants of lending.
The primary focus in this article is on bank
capital, but other potentially important
determinants include the availability of
internally generated funds and economic
conditions.
Bank capital. I emphasize two channels
through which a bank's capital may influence its lending. First, a bank's capital will
influence its attractiveness to uninsured
depositors because it serves as a cushion
protecting depositors from losses if the
value of the bank's assets should decline.
Thus, because a bank's capital makes it
easier for the bank to obtain funds for
increased lending, I expect a positive relationship between a bank's capital and its
loan growth.4
The existence of deposit insurance
weakens the link between a bank's capital
and its ability to attract deposits; when
depositors are fully insured, they are unconcerned with the soundness of their bank,
and therefore, the link between bank capital
and the ability of the bank to raise funds is

See Bernanke and Gertler (1989) and Moore (forthcoming) for theoretical models stressing the importance of capital in borrower-lender relationships and
Bernanke and Gertler (1987) for a model stressing the
importance of capital in bank-depositor relationships
in particular.
4

5 Short and Gunther (1988) found that among Texas
banks and thrifts in the late 1980s, an institution's
deposit cost was inversely related to the institution's
capital ratio.

Uninsured sources of funds include large certificates
of deposit and interbank loans. These sources are at
least partially uninsured at a bank if there is some
uncertainty about whether the bank is covered by the
"too big to fail" doctrine.

weakened. Some linkage may remain, however, since the ability to raise funds from
uninsured sources will continue to be influenced by the probability of bank failure
and hence the amount of capital available
to the bank."-6
The second channel through which bank
capital may affect lending is through its
influence on regulatory treatment. Just as
capital serves as a cushion to protect uninsured depositors from losses, it also helps
protect the bank insurance fund from losses.
As a result, regulators are concerned about
the adequacy of bank capital. Furthermore,
because increased capital reduces risk to
the bank insurance fund, increased capital
allows a bank increased flexibility in its
operations; as a bank's capital increases, its
freedom to extend loans increases as well.
Because of the influence of a bank
holding company's capital on its relationships with both regulators and uninsured
creditors, bank holding company capital
will also influence its extension of loans.
Previous papers have typically focused on
accounting values of capital in investigating
the relationship between capital and lending. This article builds on previous studies
by including the market value of capital in
the examination of the impact of capital on
lending. (The market value of a bank holding
company's capital is computed by multiplying the number of its shares of common
stock outstanding by the price per share.)
I include a measure of the market value
of capital because accounting measures of
capital may be flawed, and therefore may
not contain all of the information relevant
to the relationship between bank capital
and lending. For example, book measures
of capital are typically computed with assets
valued at their historical cost, regardless of
subsequent changes in their values. Using
flawed accounting measures of capital to
assess the role of capital in the lending
process may result in inaccurate measurement of the relationship between capital
and lending.
Internal funds. As described above, one
of the benefits of increased capital is the

reduction in the cost of obtaining outside
funds. The cost of attracting these funds,
however, may remain above the cost of
internal funds; in this case, the availability
of internal funds will influence the bank
holding company's growth. A large flow of
internal funds will make it less costly for
the bank to expand lending, and hence, I
expect a positive relationship between the
availability of internal funds and loan growth.
Economic conditions. In addition to
measures of financial condition, lending
may also be affected by economic conditions that influence banks' perception of
the general level of credit risk and borrowers' demand for credit. Strong economic
activity in a bank's market area will increase
the demand for credit by the bank's borrowers and will also increase the bank's
willingness to lend. I therefore expect a
positive relationship between economic
activity and loan growth.
The rest of this article focuses on the relationship between capital and loan growth.
For a full analysis of the effects of capital,
internal funds, and economic conditions
on loan growth, see Moore (1992), where
the relative impact of each determinant is
assessed simultaneously.

ratios were rising, on average, during my
sample period. From the end of 1990 to the
end of 1991, the ratio of the book value of
capital to assets rose from 6.39 percent to
6.53 percent, while the ratio of the market
value of capital to assets rose from 5.44
percent to 8.12 percent. The average of
these ratios over time is shown in Chart 1.
While the ratios are similar on average (5.87
percent for market capital/assets and 6.01
percent for book capital to assets), it is
apparent from the chart that the market
measure is considerably more volatile than
the book measure. This suggests that the
market measure may be more sensitive
than the book measure to events that change
the "true" value of bank holding company
capital.
Another way to compare the book and
market capital-to-asset ratios is to look at
the ratios across holding companies, which
is the approach I emphasize. Chart 2 shows
median book and market capital-to-asset
ratios by decile for bank holding companies
for year-end 1990. The chart reveals that
there is greater dispersion across holding
companies in market values than in book
values, as indicated by the greater slope of
the trend line for market ratios than for
book ratios.

Relationship Between Book
and Market Values of Capital
Chart 1
To assess the influence of market value
capital on bank lending, it is necessary to
limit the sample to bank holding companies
with publicly traded stock. The data for
this article were obtained from bank call
reports, bank holding company call reports,
and the COMPUSTAT data base. The sample
includes observations on 124 bank holding
companies and their subsidiary banks. The
data were drawn from the fourth quarters
of 1990 and 1991, allowing me to explain
loan growth during 1991.
Before empirically assessing the association of both book value and market value
capital with loan growth, it is useful to
examine the capital measures themselves.
Both the book and market capital-to-asset

Average Capital-to-Asset Ratios
Percent

SOURCE OF PRIMARY DATA: COMPUSTAT data base.

Chart 2
Median Capital-to-Asset Ratios
by Decile, 1990:4
Percent

Market Value
10 -

Book Value

—

Trend: Market Value

— * Trend: Book Value

^ f I I I
.1
2

ing companies that ranked medium for
market value, 42.9 percent also ranked
medium for book value. And among the
forty-two holding companies ranked high
for market value, 71.4 percent also ranked
high for book value.
Although the two capital ratios tend to
have a positive relationship with each other,
there are some discrepancies between the
two measures. For example, among the
forty-one holding companies with low book
value, fifteen (or 35.8 percent) have either
medium or high market value. Hence, while
the two measures are correlated, the correlation is far from perfect, suggesting that
each may have an independent effect on
loan growth.

Capital ratio by decile
SOURCE OF PRIMARY DATA: COMPUSTAT data base.

Finally, although book value exhibits less
variation than market value, I would like to
know what sort of relationship, if any, exists
between the two measures. To investigate
the relationship, I use the following procedure: bank holding companies' book and
market capital-to-asset ratios are classified
as low, medium, or high, where the classifications are formed by sorting the companies
according to their capital-to-asset ratios and
then dividing the sample of holding companies into thirds. For example, the holding
companies classified as having low market
capital-to-asset ratios are those that are in
the bottom third of holding companies as
ranked by market capital-to-asset ratios.
Chart 3 shows the relationship between
book and market capital-to-asset ratios,
using the above classifications. First, there
is a positive association between book and
market measures; among the forty-one
holding companies that ranked low for
market value, 63.4 percent also ranked low
for book value. Among the forty-two hold-

Empirical Results: What Explains
Variation in Loan Growth?
While lending volume declined slightly
on average for the sample of bank holding
companies, there was a great deal of dispersion in loan growth rates. Chart 4 shows
the median rate of loan growth between
the fourth quarter of 1990 and the fourth
quarter of 1991 by decile." Median loan
growth was -25.3 percent in the lowest

Chart 3
Distribution of Capital-to-Asset Ratios
Book and Market Measures, 1990:4
Number of bank holding companies

| k l High Book Ratio

Low market ratio

Loans refers to the sum of loans and leases.

Low Book Ratio
Medium Book Ratio

Medium market ratio

Hiah market ratio

SOURCE OF PRIMARY DATA: COMPUSTAT data base.

Chart 4

Chart 5

Median Loan Growth by Decile
Bank Holding Companies, 1990:4-1991:4

Median Loan Growth by Book and Market
Capital-to-Asset Quintiles

Percent

1 o '

Loan growth by decile
SOURCE OF PRIMARY DATA: COMPUSTAT data base.

SOURCE OF PRIMARY DATA: COMPUSTAT data base.

decile, compared with 28.9 percent in the
highest decile. I now turn to our assessment
of the ability of book and market measures
of bank capital to explain the variation in
the rate of loan growth across bank holding companies.
Basic approach. My basic approach for
investigating the effect of an explanatory
variable on loan growth is to divide the
holding companies into quintiles based on
their values of the explanatory variable.
The relationship between the explanatory
variable and loan growth is then revealed
by the pattern in median loan growth across
quintiles.8
I apply the basic approach to both the
book and market capital-to-asset ratios and
show the results in Chart 5. As this chart
shows, both capital measures have a positive relationship with loan growth; i.e.,
median loan growth is higher in the higher
capital ratio quintiles than in the lower
capital ratio quintiles. Within the lowest
capital quintiles, loans declined by roughly
9 percent, while within the highest quintiles, lending increased by 3 percent to 4
percent. In addition to showing the median
loan growth rates across capital ratio quin-

tiles, the chart also displays trend lines
showing the effect of moving across quintiles. Both the trend line for the market
measure and the trend line for the book
measure show the positive relationship
between capital ratios and loan growth rates.
These results are consistent with my prediction.9 I expected the capital measures
to have a positive effect on loan growth.
Poorly capitalized bank holding companies
will find it difficult to grow, due to regulatory scrutiny or difficulty in raising funds
via uninsured sources, while well-capitalized
bank holding companies will be able to
grow, due to more favorable regulatory
treatment or greater ability to raise funds
via uninsured sources.

The results obtained with this methodology are
confirmed via econometric analysis in Moore (1992).
T h e results reported there are qualitatively identical to
those reported here.
8

The result that loan growth is positively related to
the book value of the capital-to-asset ratio is consistent with the results in Bernanke and Lown (1991),
Clair and Yeats (1991), Klemme and Robinson (1992),
and Peek and Rosengren (1991).

In addition to having positive slopes, the
two trend lines appear nearly identical,
leading one to wonder whether the two
capital ratios are really saying the same
thing; i.e., is there independent information
within each capital measure, or is knowing
one of them just as useful as knowing both
of them when explaining loan growth rates?
Enhanced approach. To address the
question of whether there is independent
infomiation within the two capital measures,
I employ a slightly different method of
analysis. Bank holding companies' book
and market capital-to-asset ratios are classified as low, medium, or high, using the
same classification method as was used in
Chait 3. I then examine median loan growth
rates among the resulting nine categories of
bank holding companies. Arranging the data
as in Chart 6 allows me to hold one measure
of the capital-to-asset ratio roughly constant
and then see whether the median loan
growth rate varies when moving across the
other measure of the capital-to-asset ratio.

Chart 6
Median Loan Growth by Book and Market
Capital-to-Asset Ratio Categories
Percent

Low market

Medium market

High market

SOURCE OF PRIMARY DATA: COMPUSTAT data base.

This technique reveals that there is independent information in the book and market
capital-to-asset ratios.10 First, consider the
holding companies with low book capitalto-asset ratios; these are shown in dark blue
in Chart 6. Among these holding companies,
moving to the right across the chart shows
how loan growth changes when moving
into higher market capital-to-asset ratios;
loan growth rises from -9-60 percent in the
low market capital-to-asset ratio subgroup,
to 0.08 percent in the medium market capitalto-asset ratio subgroup, and to 0.91 percent
in the high market capital-to-asset ratio subgroup. Hence, within the low book capitalto-asset ratio group, moving to higher market
capital-to-asset ratio categories is associated
with higher rates of loan growth, especially
when moving from the low market capital-toasset ratio subgroup to the medium market
capital-to-asset subgroup. This general pattern can also be seen for the holding com-

panies with medium and high book capitalto-asset ratios, reinforcing the conclusion
that the market value of the capital-to-asset
ratio has a positive influence on loan growth,
even after controlling for the influence of
the book capital-to-asset ratio.
Another way to analyze Chart 6 is to look
at the behavior of loan growth across book
capital-to-asset ratio categories, holding the
market capital-to-asset ratio category fixed.
Among bank holding companies in the low
market capital-to-asset ratio category (the
group on the left side of Chart 6), moving
from the left to the right of the group
shows that median loan growth rates are
higher as the book value capital-to-asset
ratio rises. This trend can also be seen for
the holding companies with medium and
high capital-to-asset ratios, which shows
that the book capital-to-asset ratio has a
positive influence on loan growth independent of the influence of the market capitalto-asset ratio. Again, this supports the
conclusion of independent information in
the book and market capital-to-asset ratios.

10 Moore (1992) obtains similar results using a regression approach.

These results suggest that the market's
valuation of a bank holding company's
capital contains useful information regarding the company's ability to grow. This

information is not contained in the book
value, and thus, including this information
may better reflect the "true" value of capital.

Conclusion
I examine the influence of bank holding
company capital on loan growth and find
that the book value of a bank holding company's capital-to-asset ratio has a positive
relationship with loan growth. In addition,
I include a measure of the market value of
capital in an effort to improve the measurement of the value of a bank holding company's capital. If an accounting system
inaccurately measures the "true" value of
bank capital, and if the market is able—at
least in part—to see through the veil of
accounting, then the market's valuation of a
bank will contain information about the
holding company's value not reflected in
the accounting valuation. I find that the
market value of a bank holding company's
capital-to-asset ratio also has a positive
relationship with loan growth. These results
are consistent with the view that a bank
holding company's market value reflects
information about its value that is not captured in accounting measures.

My findings suggest that an adverse shock
to a bank holding company's capital, measured either in book or market terms, is
likely to impair the company's lending
capacity. The importance of capital that I
have identified at individual bank holding
companies suggests that if a shock hits a
region's bank holding companies simultaneously, then credit availability within the
region may be adversely affected, which
then could lead to a reduction in economic
activity within the region. The possibility of
such developments may lead a state whose
banking industry is crippled by insufficient
capital to seek additional capital by opening
its borders to allow entry by out-of-state
bank holding companies. Consistent with
this view, Gunther (1992) provides evidence
pointing to a positive relationship between
regional banking difficulties and the openness of recently adopted interstate banking
laws. Such reductions in regulatory impediments to capital mobility should improve
the allocation of capital in banking by
allowing banking organizations to respond
more readily to differences in opportunities
across regions.

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Full text of Financial Industry Studies : December 1992

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