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f EDERALRESERVE
OfDALLAS
FEDERAL
RESERVE BANK
BANKOF
OF
DALLAS
FEDERAL
Third
thIrdQuarter
Third
Quarter 1992
1992
•
••
conOIlllC
cononnc eVlew
conOllllC
Malley and
and Output:
Oulpul:
alld
Olllfilll:
Malley
Correl{/Iion 01'
01'
C
ausali{)'?
Corre/alion
or Cal/salil)'?
Callsa/it),?
Correlalioll
Sco!!
Freeman
SCOII Freeman
Scott
Loa
II Croll'lb
Groll'lb and
(/nd
Wall
(lnd
Q"{/II~)': Some
Some
LaC/II
LOCi I/ QI/ahly:
Qlla/i!)':
Sollie
Loall
Prelimi7lar)'' El'idellce
Pre/imiIlClr)
EI'ie/ellce
PreliminalJ'
Ellidellee
ji'om
T
exC/s BC/1/ks
}i'01n
Banks
ji'Olll Te.ras
7e.l'lls
Ballks
Robert
Clair
RODert T
T ClaIr
1Wllell
17bell Will/be
Wililbe
UII iled
Wbell
Will Ibe United
S
iales Groll'
Slale.s
(/1'010 0111
Oul of
oj
J~Clles
Its
Its Foreigll
Foreigll Debl?
Debt?
lis
foreign
John
John K
K.. HIli
HIli
K
This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org)
Economic Review
Federal ReS8f1lf! Bank of Dallas
RoM" D. MtT..r, Jr.
- , - - ... 00IIt-0Ik.-
TOllY J. S1tv"lio
hr/1o'ioo"-_o.t--.QIkw
M_,floselbhn
s.... ............ __ fJl""-"
W. Mic:a..1 Co.
~"--..,t-.,,,..
Glflld P. O'OriKoII, Jr.
IIaI,*-IW,",- _ _
Sltphin P. A. Brown
Awrnv.c-""'..... IIIIIs..-w.-r
Economists
Zsol! Beesl
Robert T Clair
John V 0111:11
Kanneth M EmBfY
Roben W Gilmer
DavId M Gould
W,lIlam C Gruben
Joseph H Haslag
Evan F K08IlIg
O'AtI! M Pe!flfSefl
Kann R PIII!1ips
rlOlla 0 Slgalla
lcrll Tf'YIor
John H Wet:tl
MartA WyrN
I(IMtIJ YealS
MIne K YUceI
Rn"rch AssocI'ln
Prolesscr Nathan S Balke
Southern Methodist LklMKsiry
I'l'Olessor Thomas 8 fomtr,o
Southern Milthodisl Un~iry
ProI8S$Df
Scan freeman
University of reJIas
Professor Gregory W Huffman
Southern Methodisr UniVilfsif)l
Professor Roy J Ruffin
Universlry of Houston
PfciesSO' Ping Wang
Pennsy/vama Srars Ikweisity
Editon
-"""
c.oJO'Ned
Vrgna M Rogerl
R.Nw .. tdIiI,IItd by INI FtOenIl IIHerwe Bull ct o.!lu TIIt_
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fIewwe IIInl oI0111n. SQtlI:IIIItDlltu, T_7S222.1214}9:22·52S1
NtIdn ",.., .. fllllllIIIIII ~ !hi condillOll 'lN1 1he muot:I' II 0'edittII i~ 1M AtsurttI
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DIoImnInlIl pCMdId 'NIdI. """ 01 .... ~ICII ~ IN rtplnl8Cl""'ll
Contents
Page I
Money cmd Output:
Correlation 01' Causality?
ScoM Freeman
111e c.:orrebtion hetween ch,,"!.(cs in the nalion's loul
supply of mo ney ;md subsequent ch.ang...-s in reo.t OUtput has led
some people to infer Ihat polkymakcrs, by changing the mOney
supply, G i n stim u1:l1c or mexler:llc the nation's real OUlPU!.
Scott Fl't!cm:lIl argues that th is conclusion mOly be i nappropriate. Freeman distinguish..:s '"side mOlley, the money
cre:ned oy hanks through their It..:nding, from olltslde mOlley,
the money thl' F(:'<icl'3l Rt"i(!IVC prints. He shows that anticipatory increases in bank lending may aCI.."Qum for the rise in the
money supply that o ft!!" precedes an c.xp:msio n in t'C::l.1 OUtput.
linder this intcrpn..t:uio n, incrt:3ses in the money supply that
arc due to Federal Reserve 41ctJo n resull in higher prices, with
no increase 10 real output Thu:., the existence of a correlation
1x.1ween money and output tJocs IlOI necessarily Imply that
Fed-enginet."f\.-d increases in the money supply have tl.':ll t.lTccts.
Page 9
Loan Growth and
Loan Quality: Some
Preliminary Evidence
ji'0117 Teras Banks
Robert T Clair
Following the failures o( deposito ry institutions in the
1980s, many analysts roncluded th.lt the r.. pid growth of
lending activity and the <icterior.nion of loon quality were
related. Roben T. Cl:lir testS lhis rt:l:Hionship after separdting
loan growth by its source: inc reased It!nding to new or
existing custOIlll.:l'S, bank mergers, ;rnd acq uiSitions of f:lik:d
banks The preliminary evidence suggeSls th:1I additional
lending 10 new or (':"xisting cu~tomcrs beyond what might be
no nna l at a given stage o( the busine"5 cycle lower.; loan
quality after a thn.'C-year lag. This relationship. based on
e vidence from Texas banks. \V"... ~ especially strong at banks
with below-average capitalization.
,\{OI al110an growth. however, will lead 10 lower loan
quali[}'. Loan growth during an econo mic expansion is to btexpecled 3S loan demand increases. Furthemlo re. well·
C'.Ipil3lized banks wen: able 10 grow very rapidly and main·
t.... in loan quality.
(Conlimled on tbe next page)
Contents
(Comimtedjrom previous page)
Loa71 G7'Owth and
Loan QUCllity: Some
PreliminClIY EVidence
/rom 7i?xas Banks
Robert T. CI3ir
One mt'lhod of incrc:ls ing loan lending whi le maintaining 1(Y,m quality
W'.!S
through lhe purchase of frilled banks
wi th the assi:-.tancc of the Federal [)eposit lnslIl1tn<:t: Corpora-
tion (FDIC). Of w ursc. tllt:,.,!.! purchast:s inc reased lending
o nly for the acquiring banks :mu did 1101 rclk '<:l an incrc:lse
in Iota I lending for tbe banking industry. Furthermore, it is
possible th:.1 FDIC resolut ion procedures have discourdgc...xI
the acqUisitio n o f weak but sti ll solvent IXlOks hy stronger
banks a nd :Ire lhcreby slowing the r.ue of m.'Ctk:d consolidalion in the banking industry
Page 23
When Will the UnUed
Stales Grow QuI of
Its Foreign Debt?
John K. Hilt
In a 1989 article In this R(!/J/('u'. Jo hn K. HIli argued lhat
the mere aging or the h~hy hoo m Rt:ncr.llion would ca use the
UnitL't.! Sta tt:.~ to lx.'COIllt: a majo r ("".!pita] exporter by the end o r
the century, To reac h that concill:..ion, he assumed that riSing
U.s Clpital outflows could he O'thsorhcd by the rest o f the
world wi thoUl :1 d""dinc in inlt:rt'S\ r.tlc:... tn this article, be considers the reasonablcnc s.<; of thtlt assumption and reevalu:Hes
the accur.Icy o f his earlier projections.
Hilt first examines the demogr.!phics of other major countries to s(.'(: if thcy could Support a r.lpid turnaround in the U.S.
capital account. The resutt:i arc decidedly nqr.ttivc. An analysis
of c:apita] flows bast.xI on <lemographic conditions in the unitt.-d
Statcs, Japan. Gennany, ;tnd the United Kingdom suggests that
lhe united Stales could remain a net capital exporter th roughOut this dec:tdc and into the I:'drly part of the next CL"Otury.
De..-pite these finding.-., I Iill conlinm.·.. to :..uppon Ius earlier pnT
jeaions He argues thaI ncw C'.Ipilal dent:mds made by former
Communist and dL"Vclopmg countrics will suppon inlerest rates
and help to raise the Inlemauonal inve:.lIllcnl posItions of all
industrialized countries. incluiling the UniK-d Stltcs.
$cO" Freeman
Departmem 01Economics
University 01Te)(as, Austin
Money and Output: Correlation or Causality?
A puzzle
AI the center of monelar), economics is a
puzzling ol)Serv;llior) : irlnovalions (u nex pected
surgl's) in thl' n:ltion's total supply of money arc
hisloric:rlly t:()rrc1:ued with inr1Ovation.~ in real output StanJ:l rd monel:lry et:ontKnics can l':lsi ly exp!:.lin
why an in(.'re:l.~e in the lllllnber of dollars will
incl'l'a:'>C the prin:s of good s and thus nominal output. the dollar V"llle of thl' economy's pro dlK1ion.
(jut why shOllld the nlilnher of nearly fictitious items (:;dh:d dollars he linkt,.'1.1to the amount
of I'l'al gO(Kls p roducl'd hy workers and mach ines!
c'rn dollars make worker ... more inlelligl'nt o r
n:dlKl' the hreakdown of Illachinery?
1111.' question is of inlerest to policymaker..
: IS wdl as ;tt::ldemit:s 111e Ft.--deral Reserve System
has;l gl'l':lt dt,.';d of conlml over the money supply
of thl' United Stall's. If ch:ulges in !he mOl1cy
su pply tOll y C:!lISC dl:tnges in rc;1 1 output, the Ft."1.I
can Mimtllate (or hold h:Kk) the n:ltion's real
production hy lll:lnipu1:rting the money .supply. A
Ill(Klei.lIion of tlte husinc.o;.s cycle might then be
within the powers of the Fl'dei.ll Iksef\'l' If.
instead. changes in the money supply havt: no
effect on real output , then d'farts to stimubtt: tht:
economy through money .~lIp pl y increases will
rl'Mlit only in inflation
Thai ch:Lng<:.'s in the Illoney sllrply cause !he
(.;h;l nges in re:LI output i~ o nly one way to interpret the ohsef\'ed correla tion hetween the two It
might also he that the Olnpui t:h:lnges cauS(;,' the
money su pply to t:hange or th:H hmh Ihe money
Ml pply ;lOd Olnput ;Irc re:lcling to innovations in
some third f;l(;tor. 'Illis !:.IS! pos.~ihili ! y is the f(K'uS
of this :Irticle,
Friedman ;Ind Schwartz in their historical
studies (1 963:1 and 1963h) hrought the positive
(;.'(lrrelation hetween thl.: money supply ;rnd rcal
Economic R,"vkw _ Third Quar1",r 1992
Olltpu t to thl' attention of the' profeSSion. Positive
innovations in the tOla l .~\(x:k of money wen:
founc! to occur during expansiorls i n real l'COnomic ;Kt ivity :rnd nl.:g:Lti ve innovations duri ng
rece.o;sions In additio n , Sims ( 1972) found thai the
innova tions in the money stock preceded the
innovations i n o utput. P:ISt in novatio ns in outpu t
were o f no help in predi<:.'ting t:hanges in the
money Mo(.;k , hut pa~t innov:ltions i n the money
stock could help prt..--dict c ha n~t.:s in outpu!. I This
finding led some in Ihe profession to helieve thaI
the money sl<x:k innovations (.'all.o;cc! the outpU!
innov:llions I
However, the w.eful ness of the moneyl
output correl;lIion as ;1 guide for monetary policy
is dwllengt.'(1 by the oIk,CIV:lliorl that w hik innovatio ns in the total money st{x:k ;lre strongly correi:llcd with output, innovations in tht.: mOlletary
IXls(<-the money distrihuted h y thl.: Fe'de'r.l l
Rcscrvt.·-are no\. Cagan 096;), Sims (972), and
K j n~ :Ind PI(lsser ( 19R4) all find that innovations
in Olltrut a re n10re ,o;trongly linked to i nnovations
in inside 1/101I<:v--th:n part of the money st(x:k
When 1fl18l'8S1 rotes W81'emcludea In Ihe St<K1I8S W!m money
and outpul. il was/ound Oy SIms (1980) and by Linerman
and We.ss (1985) /hal /heir ltlfKlValJOns. flQIltIOseoi money.
helped prcchcl OOlpul Stock and WalSOtl (1989) lind mat
dclrendmf11he money dIIla restores much oIlhe predICtIVe
contem 01 monetary dala Sec S10ck and Walson lor a
sc.mm8IY 01 recelll flVeSttgalJOnS ~ro the mcney/Ou/pu/
corrBla/1OtI
In oppo$'/JOn /0 /his be/JeI. TOOItI (1910) argued /hal/he
prcct1dtJnce 01 /tic changes ~ money did not mpIy /hal
money cllanocs cauS«J /he OOlPlJl charlges HiS rcar;cn.
1IlfJ. mal me Federal Reserve rrwgnl be lorward-loolung.
d<ffers from tho reBSOfWIg /0 be presenled hete
1
consisting of deposits at banks-than to innovations in the money isslled by the Federal Reserve,
o r outside money. This ohscrv:ltion is the key to
the explanation of rhe money/ output puzzle that I
will now propose.
An explanation
Some definitions. To !>Iudy the links between
money and output, il is essential to identify carefully the components of each. First, a definition
ofreal output is nCt:d(:d. In any period 1+1, real
output (GN?'.I) is an increasing function F(.. Jof
its inputs. For Simplicity, I limit the list to the two
most obvious, curre nt labor (I.,.,) and previously
created capital (K). An important but realistic
assumption is that new investment in capital
cannot produce goods instantly-factories take
time to build . [ also assume that the productivity
of these inputs is subject to random s hocks, which
I represent with a par.uncter x/ol ' We can now
represent real output in the follOWing way:
(3) MS, E Il omilwl CIH71?1lCY + nominal (I£posits.
Currency consists solely of notes and coins
is.'Rled by the FederJ.1 Reserve. Deposits are more
complex ; they a re nO( s imply held as <-'aSh in the
vaults of b'dnks. A fract ion of deposits is held as
noninteTCSt-bc-dTing reserves in bank vaults and aI
Ihe Federal Reserve; the rest is lent to businesses
and home buyers fo r Ihe interest it generates In
this way, bank deposits are (partially) backed by
capital, be it the investments of businesses or
housing. Let liS therefore call the interest-bearing
assets of banks i,,'ennediated capital, capital that
is invested from funds gathered by banks. This
le:lds to the equation
(4)
nominal defXJSils - 110m ina/ reseroes
+ 1Iominal inlermediared capilal.
Together, equations 3 and 4 imply thai
( 5)
MS,
l!!i
110m ina/ CIl/n?ncy + lIomillal reserves
+ nominal inlemwdiated capital.
(I)
Capital may come from two sourc(.'S, direct
investment by individuals (1<,> and investment
financed by bank loans ( II,) , implying
By law, currency and reserves can only be
held in the fonn of noninterest-bearingfiat mOlley,
money created by the Feder.!! Reserve. Therefore,
these two tenns are combined in (.'q ualion 3 to get
(6) MS,
!!!
110m ilia/flat mOlley
+ lIominal illlennedialed capital
The money supply in some period t (MS,) is
defined as the total dollar vlllue of assets readily
used in making purchases--currency lind liquid
(checkable) deposits HI blmks and similar fi nancial
intermediaries,.! whic h can be w ritten
J
Each measure 01 rnoneycaiculaled by Ihlt Federal ReseNe
include, boIh CI.If16flCY and $01'716 deposits The meBSl.Ifes
d,ffer by /he variety 01 CWposils included. btllthal need nor
CMCefn us here Mosl 0I1hlt empttical studies looked at /he
most reSIf>Cl1ve delinitltYl. called M I
• Illhere were no ht::IIdtnQs 01 Cllf6flCy. Ihlt money mu/I,pIiei
wouf<t SInlPhly 10 ~ invt'rse 0I/he reservc-lCXJepos.t rallO.
which IS /tie money mu/ltpher oIIcn laughl"., introductory
16KI/;IOOI(S
2
• I/o/1//11al/lal mOlley
nomi,wl {lIIemledialed capital
x (J -t
llOminal/ial money
).
Equation 6 reveals that the total money s upply
equa ls the stock of fiat money times an expression I will refer to as the money mulliplier. The
money mu ltiplier is I plus the ratio of intermediated capital to fiat money.4 The stock of fiat
money, often called thc moncrary base---or highpowered money-is always known, as it is chosen
by the Fooeml Reserve. The money multiplier
the n reveals Ihe total money supply for any given
value of the monetary base. Consider some
examples Suppose thai people hold currency but
no deposits. '111e money mul!iplier is then simply
I, implying thai the 10(31 money supply is s imply
Ihe supply or fial money. all of it lIsed as curren",.
Federal Ra>crvc Bank or Dallas
As the use of deposits expands, there is now some
money backed by intermediated capital in addition
to the money backed by the monetary base, so
that for any given level of the monetary base.
there is more total money
Let me introduce some notation to make
equ:nion 6 mo re readable and useful. Let Al,
denote the nominal stock of fiat money, the monetary base, and tCt Q, denote the real demand for
fiat money, the number of goods that people will
give up to get the fiat money balances they desire.
Recall that H, denotes the real stock of intermediated capital. A nominal value of a variable is the
product of the price level (p,)--an average of the
prices of goods-and its real value, tbe goods that
can be purchased by the nominal val ue. This
implies that
(7)
nomilull imemlediated capilal - p, H, ' and
(8)
nominalflat mOlley
i!!
At," P, Q,.
If one substitutes these expressions into equation 6
and divides the top and bottom of the fraction by
the price level, the money multiplier is expressed
in reat terms, which will help link it to real
output. This we do in equation 9:
(9)
Notice that there are two possible sou rces of
fluctuations in the tOlal money supply--changes in
the mo netary base and changes in the money
multiplier. Changes in the monetary base are
caused by actions of the Federal Reserve. Changes
in the money multiplier. however, can occur if
changes occur in the ratio of intermediated capital
to fiat money, a ratio affected by a private decis ion-how much money to hold in currency and
deposits. The more people favor deposits relative
to currency, the greater the money multiplier and
the total money stock; that is, for each unbacked
dollar of the monetary base (fiat money), there
arc more dollars backed by bank loans and more
money in IOlal w he n the rdtio of deposits to
currency Iflcrea$Cs.
What might influence an individual's choice
of deposits o r currency? It is reasonable to expect
Econorruc Review - Third Quarter 1992
that the choice w ill be influenced by the person's
relative costs and mtes of return. Currency is
generally the more convenient of the twO, at least
for smail transactions; it takes less time and effort
to usc than checks drawn on bank deposits.
Deposits. however, offer interest and thus a better
rate of return. Most of us hold both deposits and
currency, bala ncing their relative costs and
returns. It follows that if the costs of one relative
to the other increase, Jess will be held of that
form of money. Similarly, if the rate of return of
one s ho uld risc, more of that form of money will
be he ld.~
Banks also face a c hoice of how to allocate
the deposits they r(.'(;cive between interest-bearing
assets and reserves. Reserves, whether held as
vault cash or as deposits w ith the Federal Reserve,
represent funds that banks can use to make payments at little COSt, but they pay no interest.
Therefore. the higher the rate of return available
to banks, the less banks will want to keep in
reserves and the more they will want to invest in
interest-bearing assets. In recent decades of high
intcrt.'"Sl rates, banks have tended to hold as reserves
only the minimum required by the Federal Reserve.
In earlier decades, when interest rates were lower,
nOlably during the Great Depression, banks often
held more reserves than required.
The money/ output correlation. The empirical
studies of Cagan and the others listed above
found that changes in output arc correlated w ith
changes in the money multiplier. Let us examine
an example of how this correlation might come
about. 6
• WIlilemoslolus maynol (J8ymucll allootion 10 lila CUirency
balances we hole!. /Ilis c!BeJSJO() Is not trivial 101 those
llandlJfM} largs amotNI/s 01 currency on whiclllhl1 fotegone
WI/eres/ may oe substanl,al.
• TIle eJlplana/1On 01 fh6 moneyJoutpcn Cf)((e/.a11On ptesenled
Ilere is lakf/fllrom Freeman and I-tJItman (1991). wIliCh
clfew on ideas from Sergenl and Wallace (1982) and Freeman (1986) 11"111 example ptesenled ,s only one 01 many
po$S,bte ceuses 01 a moneyloulPUl ctxrelalJOfl IllS pte-senled as an illustrallOn. fIOf as an asserl.oon 1Ila1111S me only
possible cause Se8 TobIfI (1970) and McCaIlvm (/983) 10'
allern8W& eJlJ)lanalions
3
Suppose:.' some i,lndor11 event - leads people
to believe that capital will he 1c:-.s prodU(livc (and
thus offer to pay a lower r.lle of return) in the
next peri<XI. A likely rC:lction of invt:stors wilt be
to inn"M less in the current period. Not only will
diret.l inve~lment (J(,>f:dl, hut so will im't:Stmenl
finann:d through bank loans U I, ) The effe(l on
real output is dear: it will f:111 i n the next peri(x1
as the ~su h of bmh the lower pnxlucl ivity of
<::lpit:11 and tbe lower inve.~tment In audition, the
!low of savings from inveStllll.'rlt TO other a.... scts
will drivC' down Ihe real inlert.'sl r:lte of :111 a.~s.:t....
WhaT is the effect on the money supply,
MS, = M,( I +
~: J? The low
of the money: that i:-., il will lowt'r tht' p rice level.
The.~l.' clT...'ct~ ;tre MLmmarized in FigUft: l.
The pattern predicted hy th is ana lysis fits the
d;Lla puzzled (j\'er in the i ntnxl uct io n. Changt:s in
the total 1I0m iO:I I money sto(:k arc correl:tt ...><.! w ith
changl.'~ i n re:1 1 output. 'Moreover, the two move
in the S:IllH.' dirL'Ction. with Ihe ch:tnge in money
preccding the change in output. Wh ile I cbose
only one parll!.:ul:tr shock to St:IVt.' as an illustr.ltion, the mOnC}'/Olllput corro:lation is far more
gl.'ner.ll l..Ix)k :lg:rin at the e<.ju:tlions dcfining
outp ut and lire money stock :
G.\I' = x.
return on <::lpit:d docs
F(
I.. " J. , + /I I, anu
nothing to ch:.mge the morletary hast', 11,4" hut w hat
MS, = /11,(
l +~).
aboul the money mu ltip l ier. (1 + ~: J? Fan.:d wit h
(9)
a reduction in lire 10:ll1s they <::In make ( H , ) .
h anks m ust eith.:!" ho ld more reserves o r accept
fewer d epOsits hy lowering the i.ltL' of r.:turn
offert..-'d on d eposits. therL'hy encour.lging JX'ople
to lise mor.: currency, '111e l1cm;md for fbI money
(Q,> is therefore in<.:re:rsed through some comhination of:m increast'd dem;lnd for n:seIVes and
(or currency. As we S:LW :tlxJVe,;1 decrease in the
ratio of hank loans to fia t money represents a
Eql,;u ions 2 and 9 I"t:v.:al Ihal both output :md
th l' money .,tock :tfl: i ncreasing functions of 11"
whidl repr...'sents bank loa ns o r int...'rmedi:Heu
capital. W!lat.:ver Glu:-,es b:lnk loans 10 increase
results in :10 inaease in the money supply and,
wil h a dday, in re:tI outpllt (other th ings heing
clI lwD
Active monetary policy. T he Fc..+deral Reserve
has ('(Jnsider.lhle l"Omml ovt'r the tot:11 money
supply, Given tht: ollServed fX1... it ive correlation
I~tween money :md output. Gin the Feder.!l
Reserve .~limLl1att.' Ihe econollly by t'xpanding the
stock of monl.'Y?
Let's tl)' this out The most d irect way to
inae;!se the money .... tock is to pri nt more fiat
money. Supro.sc, therdore, th at in some period t,
the mo netal)' authorit y dou bles tht;! stock of fial
mont:y, distrih ut ing tht: new money to p eople in
proportion to their holdi ngs o f money so that no
im;ollll.' is red istrihuteu Will th is hring about a
change in real output? No. This is:l p urely
nominal change, a changt' in unils. Prices w ill
douh lt;!, h ut no real decision wil l be :tffected.
PI.'Ople will chcXlse to hold tht;! s:t me rea l value o f
deposits, c:tpit:ll. reserves, and currency as before
Ix:causc no r.lIt' of relurn is changed b y th is o netime expansion of the nu rnhc::r of dollars. I n particular , tht' nom i nal change will not induce any
cha nge in rt:':tl in vestment plans or rea l output.
A pol icy of printi ng fia t money w henever i nside
money contr.!ct.s can stabilize the total money
supply and the price level b ut not re;1 1 outpu t.
decrease i n the money m u lti plier, ( I +
~: ) and
thus a decrell.'>C in the tOlal money su pply ( MS,).
Fin:Llly, what is tht: terfe('1 on tht: price level.
P,? The price level can Ix: determined from equation H, which tell us that the nominal slock o f fiat
money must equal ilS dem:1I1d in nominal tt:TIlb:
M,
(10)
0'
= p,Q,
AI
P'=Q:
T he increased dem:tnd ( incrc:tse in Q,) for:1I1
u nchangt:d stock or fi at money will r.:J i.>;I;: tht: valut'
• Examples IOCIud6 IWCh drverse evetllS as pohflCal Of milt,
IMy /fIrcalS 10 011 $U()fJIH1$. ~ droughlS affecJJng the
fall h_st. lec/YloIogical changes.
Of
8verl
unfounded
fearsoflflVCSIOtS. 8S ~/fIlhe KeytJeSlan /fadillOfl
•
Q,
Fedcnl' Rese rve Bank of Dal.l.u
Figure 1
The Model's Chain of Causes and Effects
""~ -"In PloduclMly.
.... ,.
THE REAL SECTOR/
ca~t"K, l
[)...a~ t.I.. K,l
InI&rrMdill8ll ~ t ..... 14, l
THE ~ ONETAflY SECTOR
~ I.... GNP,. , I
/ '\''==~O'l
The poce ......1tlUI. Il, I
T"-
mooe,
_~Ipl ler 1 ~ 1Is.
, • H,,o,
/
'*"
kIaroII !.~ . H,l
¥
I
T"- IoQI .....".,. >1od1 talls. MS,.
Grecn pit.'CCS of paper ca nnot substitute for the
real capital th:u banking provides."
Lessons
The .. bov!.' :malysis (or Qrnoden is of interest
not :>imply be<.'<lU5e it explains the money/ output
correlation . Any clever economist ca n come up
with :t model to explain some single bct 111is
panicula r explanation is cs[X'Cially intriguing
because it not only explains {he money/ output
correlation but in so doing explains a phenomeno n not generally a ddr~ssed by traditional models
of money- th:n inside money is Inore tightly
linked to out put than i.~ the money distributed by
the Feder.!1 Hese ..ve .
r cannot claim. however, that this simple model
rep~nts ahsol ute tmth or captures every complexity of tile beha\'ior of Inoney and output. Neverthcies.... this m<xlel illllStr:ltes two way!'> in which the
monetary economists and policymakers may have
been mislt.-d by the observed money/ output correlalion. First, the modd iIIu!>tratcs why a correlation
o!Jscn.'t.-d hetwccn two variables does not imply that
one caused the otht.,.. SetUld, it shol.....s hO'N measun:s
of money may mislead the analysis of monetary
policy by lumping logt."1.he r two very different types
of moncy. Let us examine these in turn.
Economic Review _ Third Quancr 1992
Correlation or causaUty? Although money may
be:: historically oorrcl:lIed with real o utput, we see
fro m the illustration above that this does nO(
imply that the changes in the money supply cause
the changes in o utput In the example studied,
when money :lIld output both fa ll , hath are
reacti ng to the anticipated decline in the productivity of Glpitai. As investors anticipate a reduction
in the retu rn from capital, both direct and intermediated investment fall, which reduces output.
TIle reduction in inte rmediated investment (bank
loa ns) implies a reduction in the money multiplier
~md the lotal money stock. The money stock
reacts first becausc a switch to c urrency and
reserves can be accomplished instantaneously,
while a reduction in investment will take a period
to reduce out put becausc of the delay between
the ;lct of in ....estmcnt a nd the omput it produces.
• An If!l6fesllng fea/(J((fo/ rh9rrw:Jd6J If! FleemanandHuffman
(1991) and the IslarfK1 model 01 Lackw (1988) IS Nr
IInllC!plltiJd future If!f/atIQ(lCllll st.mulsteoutput bylfldlJcHlg
pscpIc /0 SWItch from currency to 00p0sJts The effeetlS II
smart one. I'tow9V11f. $IIlCC currency hok:hngs ilIe small
reiabve /0 /tIC 118110'1$ CIIPltaJ srock
,
(In rn;my Wily!> this is similar to stcx:k 1ll:lrket
drops that occur before reces.~ions. The ~t(x: k
market can respond in:-t:.mt]y to a drop in :mticipated profits. but it takes tim!.! for [hc rcbtcd drop
in investml.!nt to show up as ;1 drop in output.)
This example dcm()n:·,trJ.tc~ a l'Olllmon pitfall
in (.'Conometric \vork involvi ng the tot:l] mont:y
supply. The money supply is a n endogcnous
variable: it rt:'dl"t:. to olher chan~cs in the <,,"omomy.
Therefore, obsclYcd correlations between money
and some other endogenous \~.I riablc (suc h as output or interest r.lles) may result from the f(.'ilCtions
of both to !>ome economic event. The observed
correlation and even precedenc~ of money innovations to output innovations in no way implies that
money innovations cause the OlLtput innovations.
It is easy to unde rstand that statistical
evidence that any twO variables movc togcthtc'r
docs not prove lh:1I ch:lnges in either ont: elus!;:s
the chang. .·s in the other; :1 third v:l ri:lhk could Ix.'
the source of hoth ch:mgc:-. The simpl!;: intuition
underlying this ex:unplc i.s that even evkk·nCl.: th;lt
o ne of the variahles c hanges first docs not prow
that the fi rst o ne to cha nge GlllM!S thc c hange in
the ()(he r. It may ag.1in be a third fa ctor th:1I GlUses
the other changes. but one variable rea ct.~ lx-fore
the rnher. Therefore, :IS Cooll.!y ,lnd LeRoy (985)
and Leamer (1 985) have ;!rgued. the direction of a
Glus.11 relatjon cannot be cstahlishl."'<.I hy tht: purdy
statistical device of establishing which v:lriable
cha nges first.
The qua ntity theory. Finally, the e xample presented here warns llgainst exclusively flx:usinH on
6
monc ta ry :t~ regal cs that treat inside and Olllside
money ;IS if they were entirdy the same Inside
money represents deposits invested through
banks into caril:11 projects. In thi!> way there is a
d irect li nk between ins idt: money and the real
e(.'(lnolll}'. In contrast. outside moncy (the mOl1e·
t;uy hasc. or flat money cre:ned hy Ihe Federal
Reserve) represents merdy unbacked pieces of
paper with no d irect link to re:ll production. It
i~ not s urpri~i nR . therefore, thaI these two forms
of money have very different links to output in
the claw.
The quantit y theory of money is so n:lOK'd
as a ."ta[cment that the total qU:lllIity of money,
not its (;o!11position. minters. This may be lme for
the prOVision of tra nsaction service." [hat money
proviues. I lowe\,ef. bOlh the d:II:1 :md the theory
de'-;l"Tihed hl:!rl.! indicllc that the links of money to
rc:tl output arc Vl:!ry different for inside ;Ind
outside money When measures of mo ney fail to
distinguish hclwcen the two. corre btions bct\veen
inside money and outplll appt::lr only as correlations between tot:l l money and output. Observing
thc l'orrc1:nion ht:twt.'"Cn tOlal mo ney and OUlput.
thc Fcder.. l Rt.-scrvc quite n:llurally might hope
that thc (oUlside) mo ncy the Fed prints will
incrt:'.I!>C output. Tht.·sc hopt:s will be d isappoinled
if output is only 1\:1:lted to inside money_ Ir the
money/ oUi put correlation is to be studied as :J.
guidt: 10 mo netary policy. o nly the links between
output and Fedl.!r:ll Rcserve actions should he
examined.
Federal Rese rvt' Bank of Da LW
References
Cagan, Philip 09(5), [)etenlljllanfs alld Effects of
Changes;1I the
Money Stock, }8 7~ 1960
( New York: Nalio nal Bureau of Economic
Research),
u.s.
Cooley, 1110 m:ls, and Stephen leRoy (985),
~ AtheoretiCII Macrocconomics----A Critique,"
Allan Mellzer, Gamegfc-Rocbester Conference
Sen"es on Public Policy 22: 25S-303.
Lillcrman , Roben , and Laurence Weiss (985),
"Money, Real Interest Rates, and Output: A
Reinterpretation of U.S. Postwar D3la ,~
Econometn"C"J. 53 Qanuary): 129-56.
j Ollrnal of Monetary Economics 16: 283-308.
~A ReconsiderAtion of
Sims' Evidence Concerning Monelarism, ~
McCallum, Hennen (1983 ),
Freeman, Scot! (986), "Inside Money, MonetaI)'
Contmctions, and Welrare ,~ Canudianjoumal
Economics {.etters 13: 167-71.
of Economics 19: 87-98.
- -- and Gregol)' Huffman (991), " Inside
Moncy, Output, and C:Lusa lity." }IItenwtionul
Economic R(,.>tJiew 32 (August): 615-67.
Sargent, TIl omas, and Neil Walbce (982), "The
Real- Bins Doctri ne vs. The Quantity Theory:
A Recond liation,H joumal of Political
economy 90 (December): 1212- 236.
Friedman, Milton, and Ann;! Schwa.rtz 0%3a),
" ~'l oney and Business Cyclcs,~ Rc>tJiewof
Economics {Hul Statistics 45 (February): 32-64
Sims, Christopher (1972), "Money, Income, and
- - - and - - - 0963h), A Monetary History of
the Uniled Stales (Princeton , N .J. : Princeton
- - - (1980),
University Press).
Causality ,~
American Economic Review 62
(September):
54~52.
~Compa rison of Interwar and
Postwar Cycles: Monetarism Reconsidcred,~
Amen"am Ecouomic Review 70 (May): 250-57.
King, Roben, and Charlt:s plosser (984), "Money,
Credit , and Prices in a Re;1 1 Business Cycle, ~
Amen"aOi Ecollomic Review 74 Qune): 363-80.
Stock. james, and Mark Watson (989), "Interpreting the Evidence on Money- Incomc Causality,"
JOIln/al of &Ollometn"cs 010 Qanuary): 161-81.
Lacker, jeffrey (988), "" Inside Money and Real
O utput ,'· Economic /.ellers 28: 9-14 .
Tobin , jamcs (970), "Money and Income: Post
Hoc Ergo Propter I loc?~ Quarterly journal of
EcOllomics 84 (May): 328-29.
Leamer, Edward (1985), "Vector Autoregressions
for Calls;!l In ference?~ in Karl Brunner and
Econ o m ic Review - Th Ird Qua n c r 1992
7
Robert T. Clair
Senior EconomiSI and Policy Advisor
Federal Reserve Bank 01 Dallas
Loan Growth and Loan Quality:
Some Preliminary Evidence from Texas Banks
F
IJIII)\\'ing Ill ...• bilun..'s (If nullwf<!ll.... d<..·I'}()·... ilory
in:-.lillllion."i in Ihl.: ll}xO:-.. lJIany a n aly.~ls dl'l.:\\ 11K'
c<mclllSi(ln (1):11 IIl ....,.t.: W : I.... :1 rei:tlilH1sllip hcTWt.:en
r;'lpid gro\\'lh (If kndin).: :lcth'iT Y and lk- t c riol ~ l tio ll
01 10:111 qll:lllty TIl(: 1'I.; l;!ltonship beTwl.:ell lo:m
gro\\'th and 10:111 quality b compli.:x. lIo\n:n:r. and
~:-Ola hl i ... h in!-! Ihe rebllonshi p 1,..;l w ...·l'n gro\\'lh :md
quality I\;qui rl':-' I.:x:unin ing diffcn,'n! ....ourCl':-. o f
growTh and l'stim;nillg Ihl.: :ICI U:11 10;111 qu:dity \\ ilh
commonty u:-.o,;d quality raTios ..~ltlh :1:-0 nonrx:rformi ng loa n I.nilh and dl:lrgL'-otl r.lll·:-'
I'rclimin:IIY .... \ id ....Ill'L· hax'tl o n d;lta fr0111
Texa:-o hank:-. in(l i(.·;lIl·" tl1:11 loan j.!Iowtll through
addltion;)1 lendi ng [0 ilL'\\' or .... XI... l lIlg nl.... to!lll'r.( i Il1L' rnall~ g;,:n ...·I':IIL,d ).,:1'1)\\ [h) in uLllly itnpnl\'l's
m ....a.. uf<..·d nedit qualiTy but 10\\,;,:1"0 qU:l lil }' :Ifll.:r a
lag Thi:-. rt::-.ult ,.. compkh.:ly L'( lIhbtcnl with the
dla'1!o.:' Ihal SlJIll;,: h:.mk... j.trL·\\ 100 ql llek ly :lnd wcrt:
unahk' to 1ll;'lIntain cn.:dil qualilY '11K' po~ili\'""
initial .... OcCi:-. :Ind till' Ia~ in th ..· rd:llionship Ix·I\\' ......·/l
loa[\ gro\\,t h :lnd qll:lllt)' d,,·h.:rior:ll ion ."iugg....st IIKI!
"" :lrly d....l t:ctl0n of l k·din .... i n qU:'l lil )' b diflkuh
:1I1d a c llall .... ngL· 10 h:tnk l\\an:'lgc1':-'. dir....l ·tors. :md
t'X;IIll IIl .... rs
Th ...· rd :lI ionship Ix·! "'......·n IO: 1Il growth :Ind
10:111 q ualil Y dL'to.:'rior:ll loll appe:'lfs 10 depend on
:I h:lnk':-. I.:lj1.lIty I'}( ),~i lion Rapid ly :.:rowi ng h:lnks
\\ilh high kn·1:; of ....qllil}' did nOI sho \\ "'vidL'ncl'
of a dl:'ll'fio'~ltion in lo an quality. Thi... r....:-.ult
:-,uPI'}(m:-. l'Urrl'nt pn)gr.lllb ()f Glpital-h:l:-o...,d
sllp.... r\'i .. ion of h:lnk:-.
Loan growth Ihrough Ill.... :Kqui:-.ilion o f oth.... r
hank:-. kXlern:llIy g ..'ncr.l l ..'t1 gmwl h ) ha:-. (lin .... r.... nl
dit'L'I~ on loan qll;!lil)'. dqx:nding 01\ Ih..· [ype of
:lCqu;"it ion. Thl' acqui"iition o f bikd b:lIlk!'i wiTh
:I.... SI:-.I:11ll".... fmm I h~ Fl'tlcr.l1 l).... pO:-.il In:-our.lnn·
U)Q'}()r.llion (FDIC) typic l ll}' iIllPf( )\'L'S n ....dit
t:COnomi c R"",k-w _ Third Qua.ner 1992
qualily In c() nll~ ! :-.1. loan growth through mcrgers
:' l nd a cq lli .~ itions of h: lnk.~ withOlIl any FDIC
:'1."i:-.btaIlO: Typic:ll ly low<.:1's I(mn qU; llit y The
h .... ndlrs of FDI C a....~ist an ('l' in hank :Icquisition
I\\a y be . . Iowing till' r.lt ..., of consolidalion of the
h:lnking industry hy .... ncol1l'aging banks to delay
:Kquisitio n:-. o f lrouhled b:lIlk:-. unlil the FDIC
pr( lVide:-. a ...... isl:lnn'·
Thcoreticallink between loan growth
a nd loan quality
LogIcal .. rglull,,·nls C IIl IX" made rd;lting loan
th 10 hllll ri..' l<xlIl qual it)' For .... xamplc. a bank
..L'L·king [I) inL'fl':lSC it-. mark.... t share might lower
it.. umkn\'J"illng standard:-. 10 allr.ll:t more loan
l·U:-.IOlll .... r:- TIll' undt;.·[\\ rilin ~ ... I:mdards ar~
L'rnlx)(l il'd i n IllL' nonpric.... lerrn.~ of a loa n. including colla1o.:r.d r.... quirt'm enl.~. pL'rsonal guaranlees of
horr()\\'.... r.~. :md IO:1Il l·O\'l'n:mIS. If a hank lowers
tlOnpriCL' t<.:1'Ilb 10 :llIf:Kt IlL'W 10;111 customer....
thl.: l1 it is inl'rl':lsi ng Ihe.: risk expOS\lre.: of Ihe bank
hy low.... ring lo:m qualiTy.
Ev.... n if:l h:lI1k :1It .... ll1pls to maintain thc $ lInc
crcd it standards. Ihl' nt:\V horrowers it allr:JCIS may
I'll' o f lowl'r ;1\·l't~lg .... qualil Y a:-. a re.:sult of :)(Iv<.:rse
.....·lI:l·, io n. 11' ;1 hank is alll.:lllpting to ~pin the
hll."iin ............ or Ix)rrowers tll:11 hav<.: l'stablishcd hanking rdalion:-.h ip:-o. il is :Irguahk thaI the lowestqua lily l'U:-oIOllll'..... w ill Ix' L·:lSi<.:SI to :1Itr.lct. Banks
grO\\
/ .... s/I to/hanll GcraldP O ·o"scoll. Jr. Kew'lJ Years. and
fhomBs F $I1!fllS for helplul COFIYI'ICflI$ and dlSCt.ISSIOflS
•
will work hardest to keep their hi~hest -quaJit y
borrowers Lower-quality borrowers, o n the other
hand . willl~ bid away fmm their exi.~t ing hank
more easily The bank attempting to grow will
more likely :m r.K1 !mver-quality Ix )rrowers on
average and, therefort:. experience lower loan
quality in the future.
Alternatively, a hank that fails to provicle
sufficient resources for crc..'<.!it admini.'Hr.ilio n
during periods of r:.tpid growth may have highe r
nonperfo rming loans in Ihe f\ltun.! If the IXlOk
pursues morc rJ.pid 10;10 growth hut faib to
increase resources devoted to cn...-dit :ldministration,
the new loans 111:J.y not be properly monitoH..-d
over time. Close monitoring is needcd to .~ pot
troubled credits early, hefore they grow in size
Thc misallOC:ltion of inputs Gm result in lowc.:r
loan q uality even if the bank has no t lowt:red its
underwriting stanclard.~
[t has been suggested that the collapse of
the Bank of New Engl:lOd is a IXls.'iihle ex:ullplt:
of these prohlems According to :1 relxm by the
General ACCOunting Office. the Bank of New
England more than quad mpled in size from 19H5
to 1989. Ba nk examiners cited :I S prohlems a lack
of independent loan review :lOd ollt-of-date nedit
documentation (American /kInker, Scph: ml~r 20,
1991, p. 14) During tllis period. the hank made
many loans that ultimately dt:f:l ulted These loan
losses mig ht have IlCen significant ly n...--uu<.:t.:d if
credit administration and monitoring had incrcaSt..--u
in proportion to le nding.
Analy~es of thrift bilurc.:s suggest that some
depository institutions consciously :Klopted highrisk, high-growth strategies after their capital
positions had fallen 10 nea r or he low zero. Some
b:Inks have found the mselves in :1 simil:ir position
If bank equity holde rs have lin Ie to lose because
their capital has cr<xled, they may undertake a
high-risk strategy in an effort to grow out of their
troubles. In the event that the new 10:lns default,
the loss will be horne prim:lrily by the FDIC If
these loans are repaid, the hank e q uity holdt:rs may
reap sufficient income to rLoGlpitalize the bank.
111is str.ttegy is possible only Ix.--cause feder.. 1
de posit insurance allows the hank to r.. ise whatever deposits are needed to fund the .~ t r..tegy.
This is a c l:assic example of moral hazard-that is.
the provision of insur.. nee d langes the I~havior
of the ins ured (Kane 1985)
\0
It is fully possihle. however. for loan growth
to have no <...ffeet on loan q uality o r even positive
effect.... During the recovery and expansion phases
of:l bll."iness cyde. lending increases ix.'Cause o f
strong loan demand . The .~trength of the economy
:llso increa:-.es loan quality. Consequently, loo n
growth may be correlated with an improvement in
loan quality. :I .~ nonpctforming loans are likely to
d t..'dint: in a strong economy.
The dTc..-ct o f the economy o n loa n de mand
and loan qua lity is not limited to husiness cydes
StructllrJI c hange ... in tht: financial markets could
also gc.:nt:r..ne a positive rt:lationship between loan
gruwth and loan quality For example, remOving
restrictions fro111 h:1I1ks that limited the ir ability to
serve the needs of borrowers could increase loan
wuwth at banks. Al the same time . it might open
access to new customers for banks th;!t are, on
aver..Lge o hig her-quality IXlrro wers or that permit
weater diversification.
Strong loan demand r11:!y not :Ilways result
in improved loan qua IiI}' If the dri\'ing force
llChind strong loan demand is a spt."Cl.Iiative bubble,
then the reJalionship between loan growth and
lo:m quality i.~ di.~toned . Stiglilz ( 1990) casually
defines;I huhhlc as occurring w he n -the re-J.son
that the price is high today is OII~V bec:l usc investors 1~lieve that the sc::l1 ing price will he hig h
tomorn lw-when ·fund:unental' f:lCtors do not
st..oci11 to justify :>ouch :1 pricc·· ( p. 13). Shiller (1989)
h:ls shown evidence that speculative bubbles m:!y
exist fo r stocks, ho nds, :md residenti:11 real estate.
The decade of tht..' 1900s saw an inc rease in assethased lending in hoth re;ll estate and corporJ.tl.'
loan transactio ns. Because repayment of assetb:lsed loans depends primarily o n the future
selling price of the asset I~ing fi nanced, the
collapsc of a speculative bubble could lead to
dcterior..ltion of loan quality, especia lly among
asset-b;lsed loans, such as re:11 estate loa ns and
loans for co rpor..llc restructuring.
It is undc;!f if 10:10 growth should be blamed
fur the dl..-cline in I(xln qua lity follow in~ the bursting
of a speculative buhble Cc.:nainly, if the loan
gn)\\1h had Ix.-cn more moder:.lte, Ihe bubble might
have 1x.'Cn smaller o r might never have been
fonnc..--U On the otm.'f h:md. the driving force behind
the hubble W:1S the expc.."'"Ct:l\ic)Ils of Ihe IXlrrowcrs.
Furthermore, the hursting of a ~pecu l ative bubble
often results in an t:('()nomic downturn th:lt will
fn:lr:na l R~ n..r: Dank of Da llas
likdy cause dctcrior.ltion in fhl.' lo.:m ponfolio!' of
all b:mk!'>. rq.,:.lrdll.'.·.s of their growth r.ltes.
From an :m:llytic.1 1 point of vicw, it is difficul!
to .'>Cpar.lte spcnlbtive buhhle!'> from other factor!'
that caw.l: ilu!'>inc,>:- ("p. . ll:s Funlll'nllofe. some
L'COllom;st:- arguc that bubhlcs do not exist They
:Irguc that wh:LI appears to 1"'11: the hursting of a
bubhle b re:llly :1 market real·tion to nl'W inform:ltion C""..Iu::.ing the .~ha rp l.It:cline in prices. I will not
:lIfClllptiO Sl:par.lle Ihe t:fft;.'(t... of !'fX-'Cubtive bubbles
from othcr lIlovcmCnI_' in the hu,iness cycle.
The cyr:ii('";11 movcmcnb in lo:tn demand and
loan qua lity ,." ould rcsu lt in the erroneOllS condu:-ion that loan ).trowth and loan quality are necessarily related. Loan growth could result from strong
economic wowth. and loan quality could deterior.lIC from an l'conomic downturn. Consequently.
a business-cydc boolll followed by a hust will
create a pattern of loan growth follO\....cd by
dete rior'..Iting loan quality. Loan growth :lOd loa n
quality Illa}' ;Ippear t'aus:llly rdated when, in fa<.l,
they are ooth jll:-t correlated with the husincs::.
cycle drh'en by other forces. A :-tatistied analY!'is
de.'!ignL-"l1 to explain the change.~ in loan quality
needs to :Idiu.'!t for hu::.ines:.-cyde dfL'Cts.
Of cour..c. fr..lU{I CQuid he a ' 'lx'ciall''"J.se' of
loan growth heing correlated with declines in loan
quality. Extremely rapid loan WO\\th wa . . observed
at many s:l\lin~:- and loan assodations hefore their
failun...os [n some of these caS<.-'S. criminal fraud was
the driving force hehind the loan growth. I Ely
(1990) estim:lled th:1I the Fl'ller.ll Savings and
loan Insur.lOl·C Corpor.llion incurred IO"...$es of S5
hi Ilion from crimin:11 fr.\Ud at insolvent thrifts.
representing a small share or it.. . total losses, estimated to be $ [117 billion. low 10;111 qualifY in
these c..ses i." the result of the fraudulen t intent of
the lenders and. in all likelihood. the borrowers
also. The r.lpid loan growth is :1 possible symptom
of the fr.lud. but it is not rhe GIlI . . e of the fXIOr
loan quality.
Method of loan growth
hy acquisition or merger. The acquisilion might he
a hC'..Ilthy IY.lnk or a failed Iy..lnk with Ihe :Issistan('t:
of fhe FDIc:. Again, the imp:lLl on loan quality
mi~ht be quite diffen.:nt. depending on the source
of loan growth.
In this ~uticle. growth is separated into three
categories: ~rowlh through acquisition of a failed
hank with FDIC assistance. growth through an
una::.::.isted anluisilion or mergcr, or internally
general<:''li grnwth In somc C..lSC. . , the effect of each
type of growth on lo~tn quality can he suggested.
but in other case:.. it is difficu h to hypothesize.
Loan gnlwt h through the :It'quisition o f a
failed b:lnk with the assistance of the FDIC is
unlikely to afTet! loan quality adversely. In most
of these tr.lns':lttions, the FD IC n:moves the lowquality credit... from the loan pOltfolio :md agrees
to take b;u:k loans that dedine in qual ity after the
acquisition is execu ted In some other cases, the
FDIC d(X's not take any of the low-quality loons
hut , instead. provides the acqu iring institutio n
with sufficient resources to charge off the nonpcrfomling IO:tns.
Alternatively, a bank ('ould increase its 100..In
ponfolio through acquisition of other banks. The
:1C(luiring hank can limil its exposure to lowquality 100..Ins on Ihe acquired b:mk 's books. Often,
the acquin.:d hank is rL,,<]uired to charge off troubled
credits before the :u::quisition is executed. In Olhcr
cases. the acquired hank cstablishes a collecting
hank to hold the Iroubled cn."<.Iits The collecting
hank is capita lized by the shareholders o f the
acquired han k to isolate the cffects of the problem
credits from the :Icquiring bank or ba nk holding
company.
of COUTSe. not all bank mergers can be
characlcrizt:tl as one bank acquiring a nothe r. In
, Fat 6X~.
II
Pottn sclleinlr IS pt'emtSi1d on rapK1 growtn
ro generalll suHoBnl cash flows
The SIX"<:ific method utilized to increase the
loan portfolio (:ould h:l\'e an efft;."Ct on the reb rion·
ship between loan growth and futu re 100.ln quality.
loan growth could he gener.lted by increasing
knding to existing customers or to new cu<;tomcl"S.
Alternatively, the 10;.10 ponfolio could he increasc.."d
Econo m ic Rt.'"Vtcw - Third Qua n c r 1992
10 cove< up rile lade 01
~"""'" results Ponb lYomsed ro double investors'
r11O;IrIe)' ., a shon peFlOd He then used lhe Iftflow 01 new
deposl/S /0 Qrv6 ".,/1(1/ aweslDB the promised cJoubIiIIg 01
funds• ." /110 \thJB C)f/rtIC/tng subs/an/sal managemern
fees PotvI covId keep the scheme go.ng so long liS the
rspidgrowth 01 f!6W 1flve5tDBpt'CNidBd w/ficJan/cashfkJws
to pay 011 the IIarber .WCS/OtS (Kaufmlln /986)
11
the GI!>C of a merger hctwcen equals. the loan
quality of the t'Ombined bank will be the aver.Jge
of the loan quality of the twO banks, wt!ighlCd hy
their rdativc sizes. In this case, loan quality is less
likely to ('hange substa mi:llly.
The effect of internal growth on I(xin quality
is the mo...t difficu lt to pr(:dicI If a bank were \0
re:.trict il:-;clf to l<Xtn growth from the growth of
existing IX>rf'Ower relationships. it would he limiting
ito; growth potential 10 Ihat of its oorrowers. lis
diversity cou ld also he limited. Seek ing o ut new
horrowcrs, however. has Ihe haz;lrds descrilx.--d
ahove, such as ad verse selection.
Altcrnativdy, intern:.ll lcY.Jn growth could result
from in<;n.;ascd lending activity in the loan participation tnllrket A bank might be ,Ible to increase
loans outstandi ng Without lowering ils undenvriting standards': Furthermore, the loan p:lrticip,ltion
market could offcr :1 bank Ihe abil ity to diversify
its loan portfolio "cross geogr.Jphic regions and
across industries in a manner th:1I lowers ()\'cr.lll
cr<.>dit risk. If, however. the loon panicipat ion
market is driven by loans to finance a speculative
huhhle, then usi ng the vehicle for loan growth
could 1I:;ld 10 lower loan quality in tilt! future.
Many of the:' highly le:'verag(.x\ tr::IIlS.1ctions of the
19HOs that are now in default or are being renegotialL-'(1 were finll nced by large pools of banks
Measuring loan quali ty
The ;ma lysis utilizes two st:lnd:lf(J measures
of loan quality: the mtio of cha rge-offs to total
loan.~ and the ratio of nonperfonning lo;ms to total
loans. Thcse m(!;!SUfCS arc proxies for the actual
pmbahi lity of a 10:.ln defaulting A cha rge-off is
the amount of a loan that a bank determines is
unlikely to be rcpaid and cou nts as a loss. Nonpe rforming loans arc defined as Irnrns Ih;1I are 90
days or more past due or have nonaccrual status.
Two measures gauging d ifferent stages of
rhos 1tTgumet'l1 IS basod on rhlI fIOf/O(1 thallhe elaSllCtry oIl1Je
supply 01 k:Ians i<l tno patl.opa/lOflI'l'J8rl(C/ 's very rwgh and
a large St7IOUfII 01 /cI/tTI$ can 00 added to lhe baIIk'S OOOI<s
...mou/ (educlllQ ,IS UI'>derwr'/IIl{J siandards
12
lo;m quality deterior:llion were used hecause any
single me;!SllTC may be inadequate in determining
loan quality. B:mks have some dis<.'felion to shift
prohlem lo;!ns from the first stage to the second
stage. In Ihe first 5t:lge of dcterior:1ting 10..1n qual ity,
loans Ix.'come no nperforming-thc borrowers fa il
to make timely payment of interest and principal
If the 10:1(1 appears unlikely to be repaid in fu ll,
Ihen in a ~ccond i>tage o f dctcrior::llion, the loan
or :.I portion of the 10:\0 is chargt.'<i off A hank can
lower i t~ nonpcrfonning loan r::ltio hy charging off
more of its nonperfonlling loans. Consequently,
both the ch:lrge-off r<lle ;md the nonperforrning
loan ratio wcrc used to assess loan quality.
These fin :lIlcial mlios, however, can be d istorted hy growth if there :Ire lagged rclationships
lx:twecn financial va riables. As a result. the ratios
aTe imperfect proxies for the actual probability of
1I loan defaulting . Loans are rarely cha rged off in
their first year. It is far more likely for a lo:tn to
ddault and he c harged o ff long afte r the loan was
fi rst extended. Consequently. there is a lagged
rciationship between the measure of [0:10 quality
and tolal loans.
1l1l::sc loan Quality meas ures do not adjust
for the lag in the rt:i:uionship Ix:twecn extending
loans and 10..1ns defaulting Consider the chargeoff r.Jte, for example; it is the mtio of charged-off
loans, which arc loans extended in previous years
that are only now be ing recognized as a loss, to
lota l curre nt loa ns, which include loans that were
made only recently :lOd, therefore, are unlikely to
havc def:lllltt.xI as yet. Essentially, the mte measures
yesterday's Illistakes relative to tcxby's base. Consequently, growth in total loans can d istort this
ratio. If, as stated ahove, leday's hase is growing,
yestcrcti y's mistakes appellr sma ller in com p:l rison
with the cmrcnt base 1.0an growth would lowcr
the charge-off rate for as long as the growth could
he ma intained, and the charge-off !':Ite would he
lower than the actual probllbility o f defau lt.
A numcn<''d l example can illuminate this point
:.Ind is presented in Table I. Suppose Uank A starts
with S 100 of loons and its growth rate is I percent
per Ye".JT; the prohability of a loan los..;; is only 0.Ql.
Assume that all loa ns have a three-year maturity
and uncolk-ctible loans are charged off in rhe
third year. In the case or Ba.nk A, its charge-off
r.lte would lx:come stable al I percent, exactly
L"qual to the probability of loan loss. Suppose
I'c:<kral Reserve Bank or DallllS
Table 1
Simulation of the Effect of Temporary Increases in loan Growth Rates
on the Measured Charge-off Rate
Bank A
Period
Loan s
1
2
3
100
101
102
102
102
102
102
102
102
102
102
102
102
102
,
5
6
7
8
9
10
11
12
13
14
Banke
BankS
8ankO
Charge -
Charge·
Charge·
off
off
off
Rate
""'"
1.00
100
110
121
132
14'
157
171
187
204
100
223
1.00
1.00
1.00
243
265
289
315
.98
99
1.00
1.00
100
1.00
Rate
loa",
.76
.76
100
110
121
132
14'
.77
.77
.77
.77
.77
.77
.77
.77
.77
157
171
204
223
244
266
290
317
346
Rate
.76
.76
.77
.77
.71
.70
.70
.77
.77
.77
.77
Charge·
011
Loans
100
110
121
132
14'
157
171
204
223
244
266
290
317
346
Rate
.76
.76
.77
.77
.71
70
.70
153
.77
.77
.77
I ·percent growth 0I 103ns and con5tant probabl tv of defauh eQUal 10 01.
BaM B conS-Ian! loan growth 01 10 pefr::ent ana eonSlanl po-obabolly 01 delau~ equal 10 0 1
Bank C onel,rne ,ncrease ,n growth raut from 10 perr::ent 10 20 pefcenl ,n P8f1od 8 and COtl$\anI probatllirty 01 detaul, equal to 01
8af111 0 one -bme fncrease In growttl rat e from 10 percenllO 20 pefcenl and one-t.me ,ncreas.e In probabll,tv 01 delauh from .01 to
""'"
02111 PerIOd 8
1I,11l1..
H,,,,
idt"nl tullo Bank ,\ C:"I.l"t:pt il gm\'" ;11
,I 10 lX'rccllt ,\ilnll:r1 1 ~1 1L' ; IIlL·n It-. dUlgL··off 1:IlV
\\o(lld :-1;1hili/L·:ll 0.-- lX'n·L'nl. 1\;l!1k U ("; m
Ill:lInt:lilllllh h)\\ ..:r t ll:lrgL·-ol"I 1~ IIL· ;1'; long :1 ... il
Gin lllaint:lll1 llw 10 pL·t"l"elll ).tro\\·,1l r:l1t:
"1"111:- ;lI1iL"l..: addn..·..;..;l'.... lllL· qllo.: ...lion of \\"IWlllLT
IIle d d :lu ll 1: 110.: t·h:mgt· ... 111 fl· ... j)(JI) ... e 10 r.:q)id IO:ln
gn m ·lll ,\ t"(lnlIXl ri ...(Jn (If 1\\ () Ill( )f o.: :-i mui:t lil)!)S
... Illl\\ ... llw di ... tinUl o tl 01 th ..: d ilh·~nl·e Sllppn.....:
hOl h IUnk C and B.ul l. I) \·"1'k.:m·tlCI.::t tempo,:lry
i,KfL\l"'\· in lllL' /-:1"1)\\[h 1~ l tl· ( Ifl(un ... from 10p...·ru·1\1 gro\\ III 10 20 j1l·rU·m :-:I1)W[11 III tht.: .... ighlh
p.,:nod 1x:l"or\· ft'[llnlln:-: to :1 "'1l';ldy lO-pern'JlI
grtl\\lh 1":111..' In th ..: C t",-· of Ii:m k C. a"HIIllI:' Ihe
prllh:IIJ!l il)" 01 a loan d dallh ing rt'lllains <:on"'lanl
at il 01. \\ IlIlt;' in lhl' (".I....l' o f Bank I). a"Sllllll· lilt"
proh:thilil Y of dd;ll1 lt ri ......'" frolll 0 _0 1 to 001 fo r
till" p.,:riod o llHgh ).:f0\\11l :lIld rL"ll1nb 10 00 1 ;Iftl'r
Fxo ll tl m ic MCl·lcw_ Third Q uan t'r 199!
lilt' hi!-lh !-IHm11l In II:rnk C\ C l:-t'. lllL" el\;lr!-l": ofr
1~!It' \\"iI1 1 t'll1po!~ lril~ f; ll llrolll 0.77 pt.'feenl 100-0
pLTu,'nl and lh..:n I\.'l u m 100 -..., IX·,T t·nl In Bank
I)".~ ea",,:. lilt" dl:It").~ ...., oil I~llt· tit-dine..; inilially 11)
070 Ix·rn.-Ilt . as in till" l·:I .~ l" of Ibnk C, but llK·n it
ri"t·s :-harply in lhl" tllird p..:riod :Iftel" lilt· growth
to I ';j Ix·rc..:nl \\ hl'1l1h\· bA~t'd ..: ffects of ext .... nd·
1I1).t nt:dll 10 !"i ... k'l'l· horfO\\"t'rS are rt.":riil".vd_
l:k .'Clll .....· (If l l,i .; b gg.... d rdali(lIl~hip. :-l11)laint·d
r.:lpld WO\\ III e l n 111.1 ... 1-; ch:IIl~"'s in t ll(.' probahililY
0 1 dd:1l11l h~ drh Ing l llL' dl..l rgl' oil" r.:11 ..· in llll'
0Pl)().~ile dir...·\·lion I'or ...·X:llllpk. mol"(.· r.:lpld
growth (:ollld tim ...· ,hl' prohahilily 01 tld":ll1ll lip
only a "'111:11 1 Ill'fl·..·nlag..· r<.:blin! 10 Ih .... rx:rn·nt:tg..:
ilKI"Cao.;e in th .... t:lll· 01" growth A:. a rc"ult. lol.:ri
dla rg .... -ofr~ \\ould n:-l' in ah:..olUlt." tnagnillldt.:. hUI
durge orf~ rdal i\ ..: 10 lot:ri lo:rns would 1':111
Of n>UN.:. 1ll:11111:li nIllA I":lpid lo:m g rowt h
"
fore\'!::r is impossible. Evcnlu:tlly, some sll<x.:k (0
econo mic growlh limits 10:111 growth In Texas, for
eX:lmple , these shocks were the decline in o il
prices and the collapse of real esl:lle wilues. When
loan growth r.ues f;I11 , the effects of growth on
dmrge-off r.ltes arc rcvcrsed and magnified. A
slowdown in loan growth causes the charge-off
rate to rise temporarily, even thou~h the probability of default may he unchanged.
The model
As Ihe dependent ,'ariables. Ihe nonperfOnlling
loan r.llio and the charge-off r:.ne were regressed on
a series of indcpendem Wlriables th:n measure the
effects of loan growth by me[hod of growth, b:lIlk
financial char.:lcteri."lics. a nd business condilions.
To capture the dynamic re1:ttionship belwet.'n loan
quality, as measured by Iht! nonpc1fomling loan
r.:llio and the charge-off rate, and loan grO\vth r,l[es.
multiple lags of the loan growlh r.:1[es weft.' used in
the regression [0 detcnnine the:: rel:nion-;hip between loan gro\.\1h and loan quality. 'Ihc estimation
lIsed dat:l from Texas h:lIlks for 197(, through 19'Xl.
Loan gro\\1h is separ.:ued into tlm:e G.IIegories: growth through FOIC-assiSled merg .... r, growth
through unassisted merger, and intern:ll growth.
Growth through FDIC-assisted merger of a fa iled
hank is defined as the total lo:ms tr.lOsferL"l.~1 to the
surviving bank as a percentage of the total loans
at that bank at the cnd of the previous period
Similarly, growth through lIn:l ~s i ~ted merger is
defined as the total loans tr,msferred to tbe surviving bank as a percentagt! of Ihe total lo.ms at that
bank in Ihe previous period. Internal growth i."
measu red as the residual growth after growth
through assisted and unassisted mergers is
removed-that is. total looms in time pcri(xl I less
loans acquired through assisted and unassisted
mergers, stated as a percentage increa.~ .... ov.... r total
10;lns in lime period I - 1.
, Measures 01 cconc:mIC cotId"IOnS al lhe CX1IJI'IIy level. inc/udrng couruy empk;1ymcnI ana gloss laxable sales 111 rt>c
COtNl/y. were 1ested but wetadroppcd Irom the regresSlOOS
lot lack 01 ssgmliClIfICC
Tht: composition of the loan ponfo lio may
also aIT..."Ct loan qU:l lity. Du ring the period unde r
study, o il prices dropped ..;harply, and the comm.... rcial real est:lle 111:1rket was dev:lsf:Jted hy overhuilding :Ind high v:1C.mcy nlt(.'S. Const."'qllently, a
b:mk that W:IS heavily expost."'<.l to energy or real
est:lle Ix)rrow .... rs would likely have higher nonperforming loan r.:llios Of charge-off nues than a
h:mk whose loan portfol io was bener diversified.
To :K("()lInl for the effect of differell(:es in loan
composition o n loan qU:l lity, the proportion of
commercial and industrial loans to tOlal loans and
the proporlion of ft:al estatt: loans to total loans
were included.
1\ h:mk sca le vari:lble (Iogarilhm of total
as.~cts) W:1S :\lso induded [0 C:l pture any effects of
hank size, such as minimum .... mcient sc:I les of
oper.:lIions Of important repllt:lIional effects. It is
possihle that large hanks may I)C" :Ible to achie ve
effi(knt Sf:ales of workOllt opcr.:lt ions that a re not
kasibk for smaller h:lnks. As a result, large ba nks
111:IY kt.ocp non performing loans o n their hooks
whil.... th .... y w(lrk Ollt rep:lymcnt schedules. Smallcr
hanks may fin d il more cfficicnt to charge off the
loss Conversely. la rgt! hanks arc more li kely to be
raising funds in the money markets, and these
mark .... ts :cppear to respond more favora bly whcn
h:mks ch~lfge ofT Irouhk. d loans rJther than carry
them as nonperforming asset..;. Therefore, large
ha nks. if they have suffident reserves, may havc
gre:lIt:r incentive to c harge o ff troubled loans to
gain more favorJblc terms in the money ma rkets.
Loan quality will alw be a function of the
current .~tate of the et'onomy Business conditions
:lrc intr<xluct:d into the nHxld hy including the
gf()wth r,ltc ()f ·kx:!s nonagriCllltur.:Il employment
in the n.:grcssions. \ Texas employment dar" are
pllblished by the Texas Employment Commission.
The struct\lre of the model is as fo llows. The
dcpemknt v:lfiah les measuring loan quality- the
nonperforming loan r.1t;O and thc cha rge-off
rate- aft.' regre:-.."Cd on the following independent
v:l riahles:
GNO\V/HO
(,"ROWifHl
(;NO Win-12
GROWI7I3
Inlernal loan growth
and three lagged values
GNO-MNG
Loan growth through ban k merger
F..-deral Rcsen'e Rank of Dallas
GRJ -/ltRG
GR2-/ltRG
GRJ-MRG
and three lagged values
GRa-FI.
GRI-F/.
GR2-F/.
GRJ-FL
toan growth through acquisition
o f failed banks and three lagged
values
I ii
log of total bank assets
Business loa ns as a percentage of
tot:11 loons
Real estmc loans as a percentage
of tot:11 loans
R;llc of Texas nonagricultur.l l
employment growth
Total equity C;lpital as a percentage
of 10t:1I :Issels
CMLRAT
RLRAT
ElI1PGROW
EQUflY
A logit-type transformation was performed on the
dependent variables because their values were
limitc.-'d in the r::lnge of 0 to I •
II is possible Ihal the negative relationship
betw(.'Cn loan growth and loon qU:1Ii1y may not
exisl for banks growing :11 relatively norma l mtes
but only for r.lpidly growing b:~nk..;. High-growth
banks were idemified and tcsled separ..lle1y from
the rest of the sample to exami ne this hypotheSiS
Banks with internal loan growth rates exceeding
four times tbe growtb rate of Texas pc..."T'SOnal income
were classified as high-growlh banks. Banks with
internal loan growth rates less than four times the
income nlte were cb ssificd as nonnaL ~
Simil:l rly, 10 measure the possible efTects of
moral haZ:lrd on b'U1k bch:1vior, the sample of
r".lpid-growth banks was split into high and low
C;lpit:ll categories . A bank was classified as a highcapital bank if its equilY capital-to-asset ratio
exceeded the ,lverage for its peer group. The
three peer groups used wen: based on total asset
size: banks with less than S 100 million in assets,
banks with at least $ 100 million in assets but les...
than 51 billion . and hanks with more than 51
billion in asscts.b
111e regr(."SSio ns were run witb annual data
from the Reports of Condition and Income filed
by Texas banks for 1976 through 1990. Texas
personal income data wcrc ohtaint..'tl from the U.S.
Bureau of Economic Analysis. The regressions
using the nonperforming loan ratio as the depen);(:OflOnUc RC:'Yicw- Third Quanc r 1992
dent v:lriable wcre estimated for 1984 to 1990, thc
period for which data were ava ilable. TIle chargeoff rate regressions were estimated with dala for
the entire period .
Regression results
The empirical results do provide (..ovidencc
that rapid loan growth will result in a dClcrioration
of loan quality. As expected, internal loan growth
worsened measured loan quality with a lag. These
empirical results support the popular notion that
rapid loan growth results in low-quality loan
portfolioS that am lead to bank fail ure.
All the regressions utili:dng nonperforming
loan ratios and charge-off " Ites as Ihe dependent
variables were statistically signifiC:lnt. The regression results for the nonperforming 10:10 r'dtio are
presented in Table 2. The adjust(.'(1 Rl values
indicate that even in the best-fining equation, less
than 20 percent of the total variation is explained.
Low Rl values, however, are common in regressions using cross-section data . The regressions for
the charge-off mte are present(.'<.i in Table 3 and fit
the data slightly better than the nonpcrformmg
loan ratio regreSSions.
• II the cleptHl(1enl variable IS X. lhefl the /oglllfanslcxmalK)(!
01 thaI va"able IS Ir>!XI(I
X)} Th,s procedvre
m(Jr)O.
/(xllcally Iranslorms the values of X. constr81fled to be
betwoon 0 8nd I.
to range from negatlv8 10 POSlllve infmity
• Tile relallOllsllip may nol be symmetrIC lor both loan growth
and loan contraction. ancl some forffll.Jlatlons restncting tile
ooservatlOfls to posillVe loan growtll WCfO cstimated Some
versions 01 lhe model were eS~fTI8ted WIth observatK)(!s
hmlted to POSItIve internal /oaIl growth Danks only The
r~wllS
were essentially the ssmo as the cst!mfltc lor the lull
"'"'"
• Exat1llfllflf1 tile maal flaZtJfcl hypotheSiS IS nollhe foevs of
Ihs artICle It IS mportant to note that ~t because a bani(
fIBs a Cap.laI ra/IO befow the peer f1'OUP averarJC. Ihe bank.
IS notflflCilssarilyQOlfl{llOl1xhib1lmaalhazarci behaVlOf_ To
hhy. a sample of
banks opersrlllO W!/tIlillhf it any cap!lal WOCJIcI be needed
It 15 po$$IbIe /hat a sampleof ssWtgs and.ban assocuwcns
wouIcI alter a wHicIf!(l/ number 01 obscrvallons to sltJdy the
ex~ maaillanJrcl behavXx mote
motalhazarciproblfJrn
"
Table 2
Regression Results for Nonperforming Loan Ratio , 1984-90
High-Growth Banks'
All Taxas Banks
Tolal
GROWTHO
GROWTHI
GROWTH2
GROWTH3
-.01766 . ,.
-.00695 •••
-.00086 •
.00006
GRO-MRG
GR t·MRG
GR2·MRG
GR3-MRG
.00092
.00155
.00342 . ,.
.00101
.00421 '
.00090
.00288
- .00445
-.01383 .. ,
- .00695 •• •
-.00059
-.00290
-.00233
-.00026
GRO-FL
GR 1·FL
GR2· FL
GR3· FL
- _00574 ...
-.00251 •• •
-.00072
.00040
Low·Equlty
- .00723 •••
- .00360 •
-.00238
- .00546 •••
- .00235 ••
- .00044
.00043
-.02926 •••
-.00765 •••
-.00004
.00441
-.00159
.00264
- .00479
-.00 125
.00 131
.00154
.00095
.00262
-.00355
- .00627
- .02150·"
- .00832 ••,
.00007
- ,00284
.00045
.00415
00'58
-.00453
- .00686
CMLRAT
RLRAT
EMPGRQW
Intercept
.05992 · "
.00865 •••
.00985 ••.
00513
-5.08019 •• .
.09393 ...
.(X:J186
.00278
- .05209 •• •
- 5,52885 •••
.024 10
.00777'
.00837··
- .05562 •••
-5.06423 •••
AdjUsted R '
Fstausllc
Observations
.1610
143.702 •••
11 ,903
0625
10.479 •••
2.133
5.750 •• ,
TA
Normal-Growth
Banks
High-Equity
0801
601
00003
.13085 •• ,
- .00107
- ,00041
-.05061 ...
-5.73915 '.'
.Om4'"
.00906 , ••
.00896 •••
.02097 •••
-5.28745 •••
.0530
6.715 .,.
1,532
.1763
131.719 •••
9,770
. Banks were cI&ss,fied as hogh -gfowth banks ,I lh8<f l ale oIl1l,..-nally geneo-aled loan growth e~ceed8d 10Uf ~fTle$ the growth rale 01
Te)(8S P8f$QOIII ,ncome
• SiogM,canl allhe .10 level .
•• SlQnllicanl al the ,05 level
••• Sign'licanl 91 the 01 level
:\ .~ predil I<.:d , till" m iti;t1 <: lIl· ..·t .. 01 int"'l"nal
grO\\t h Illl pnl \ cd I()an ( i li a li t ~· wht:n 1I 1t:;I~url'd I)~
the nllTl'll1 1l01l1X"rtorlll lllg lo:m r:1\ (0 :md the
l·h:.rg,,·-otl r.lIl' The COI,.-Okit'1l1 on the \ ':l ri:lb k-
, The movemenl •• ltlecharge-atf rale pteSf!(1red LS based 01"
I/>e regt~' resuflS &!caliSe 01 me 1og,1 tlans/olma l/Ofl
lhe coelflCoertlS ffllC3'tJ me qual'IBINe dlleclion 01 rhc
effOCI Dr.Ac..l~ be IflIe£Oleled quanMallVf'/y
16
(;N()II ~n 10 i .. nq.:.Hh l· and .. ign iflc,nt in ..·\·... f y
rq.: n.'-"~1()n for both th,,' l1onp",:r1< Irllllllg lo:tn ratio
;Ind till- d l:l r).:l·-o fi r.Lte Th..· i:tg,!.:l·d 1."11-...·("1-. o f loan
gnm th . hO\\ l·\·CL lIllTea"l' th ..· d l .l rg..· otf r.He In
till' ell:11):'" off r.ue rl'grc"!'olon 1\)1" :111 'J"..-:u-. h:1Ilk:-.
11ll' nx:lrk .... nt on CH() \\ 'TN3 j,.. .. ignifiGllli a nd
po~i l l\"'. IIldic:ui nt-: I hat III l h l" G I ~l' th ... LIKlt ...d
dTI.:n o f lo:ut j.tro\\I h w,." 10 r.11"l· till' lh:lfj.tl· on'
1:11,,-- 1\ 1I.·111por..ry incre;l ~: lIlllll' ).:nJ\\th r:'!l' o f
1o;ln ... 1X"j.!inn ing :11 !line I. will <: IU ....· til(" dl:lr<,..!..·on' r:il ..· to 1ll0\-t' in Ihe pa tll.·rn lkp llll1J III Fi).:urc
I - Till' l"egr..·.... 'ol1 l'()t.'O'i .. ,..'I1I." ,ndiGII..· \h ..· .. ;tllll.:
Ft:de r.d
'k~c n'e
R:.nk of Uall3s
Table 3
Regression Results for Loan Charge-off Rate,
1~90
High-Growth Banks'
Normal-Growth
Banks
All ie_as Banks
Tolal
High-Equity
Low-Equity
GROWTHO
GROWTH/
GROWTH2
GROWTH3
- .01860 •••
-. 00640 •• .
.00017
.00013 ••
-.00496 -••
- .00738 •••
- .00669 •••
- .00472 ••
- .00004
-.00428 •••
- .00296 •• •
-.00064
.00124 •• •
GRO-MRG
GR/·MRG
GR2-MRG
GR3·MRG
.00252 •••
.00296 •• .
.00275 ••
00012
.00474 •••
.00524 •
.00138
-.01563 ••
.00484 ••
.00421
.00441
.00539
.00155
- .01540 •
.00015
.00246 •••
.00230
.00012
-.01469 •••
-.00504 •••
,00158
-.00125
-. 00251 •
-.01233
- .01937 ••
- .00495 ••
-.00218
-.01198
-.01857 ••
- .02375 •• •
-.00644 •••
.00276 ••
-.00062
- .06761 •• •
.00038
.00019
-.04209 •• •
-3.76497 •••
- .02123
-.00646 •••
-.00683 •••
- 05284 •••
-4.31454 •••
-.04370
- .00030
-.00539 •
- .04641 •••
-4.07762 •••
-.01221
- .00891 ' "
-.00794 •••
- .05271 •••
-4.37177 •••
-.04907 •• •
.00075
-.00458 ••
- .03067 •• •
-3.93773 •• •
.1837
182.432 •••
12,902
.0883
16.634 •••
2.123
.2274
199.285 •••
10,779
GRO-FL
GR/ -FL
GR2-FL
GR3·FL
TA
CMLRAT
RLRAT
EMPGROW
Intercept
Adjusted R 2
Fstatlstic
Observabons
, Banks wer. dass~led as
Te las personal ,ncome
hogh~.OW!h
- ,00348 •••
-.00113
- .00064 ••
.0995
,1197
8.328 •• •
59'
10.663 •••
1.529
- .03231 •••
-.0065 1 •••
.00142 •••
.00010 •
banks Iithefr rale 01 rolernally gene.alad loan growth e lceeded tou r bmes the g.owth rate ot
• SogOlI.canl at the 10 level
•• Stgn,j,ca nl at the 05 level
••• Slgn'ficant &1 the at level
P:III"'rll
()f
illlplX ,\ ,,'In~ 'm (()Il(m "'d by dctt:rior.uion
111:(1 i... pr........·Ilk'd in [h~' ... illlul;u ion of thl' fiction.11
B,' llk ])
Tit ..· "'mpi r i"': ll 1"..· ... ult ... :li-;o ind ic tl ... Ih:tl :t
"'U"'I;li ll ..·d m er..·:! ... o.: in tht' ~ro\\l h I:Hl' of Io.:nding
cou ld 0",,':1\0.: Ill<." :'ppo.::u':tnn.· Ih :1\ lTl.'d it q ll :I 1i I~ l1:t ...
itllprm"'d If Ih..· inl ... rn:,lloan gro\\lh ral ... ri~l'''' :m d
r\:III;lIn ... al :t n ...·\\ lughl:"l"
k·\d,
11ll" d l...·cl on 11K"
(h:trg~:o(M ralc
\\ tlllid ho.: Iht· slim of Ihl ' ..·t)(."lfidl·nl'
......Iirll:l lnllor 11K' tl11l'rn al growth 1.11..• \':,ri:th k :tnd
II.' bggl'd \ .tllI ...•... Till.' hy po l hl"... b Ihal till' ... u m of
l ill" co.,:nkil ·n h I.... l'qual to ZI;'I"O \\;t ... I ...,~ t l"d \\'ith :lll
1'~''' lI nm k
R..,,'k w _ Th lnl Quancr 1992
1-"1 ..·... 1 :t nd rl;'jI;'Clt:d. ind iclIing t h:tI a ~kad y :-.Ial l ·
itKll:a ....... in I hl:" gro\\,t h 1: 1I1:.' 01' i nl l:.'n1:tI Il"nd ing
\\ ()ltl d rl" .... 1I11 in a I()\'l"r 1l1l":t.... ul"...d l ll:t1'g•.:-t,1T r~l\l'
T h..· p:III ...·rt1 of Ihl" lll()\'cnK'nl in th ..· dl: lr~"' -ofr
1':Ill' rl" ... uiti n,g frolll "u~ t :titll'd W'()\\lh \\oll id h.....
l 11 lld l d il1"l-rl 'n! ,ban octltrrnl \\ ilh ''''lll pt ll:t ry
g1"O\\ th 1\ '" ... 110\\ n in Flgw .., 1. Ih ..· cha rg"'-oIT r:1I1:.'
\\ould f:ll l lx.-gll1T1ing :,1 lU ll..· I ;lI1d ro.:llla in helo w
I ll\.' o rig1l1al t:ha r~t:-off mIl' lor a~ long :I ... Ih t:
h lg h..... r WO\\ Ih r.lIe could hl" l1lainlai lK'(1
T h"'rt* i~ ~Irung I;'\'idcnct: that g ro\\"l h Ih ro ugh
hank llwrgl"r IO\\ 't:rs a,... t.:t q ual it y. h:I......·d on IIll"
17
Figure 1
Figure 2
Effect on Charge-off Rate of Temporary
Increase in Loan Growth Rate
Effect on Charge-off Rate of Sustained
Increase in Loan Growth Rate
"'-'"
".
effecl on Ihe charge-off r.lle The initi;ll and the
lagged effect.s o f growth through b;mk mcrgcrs
were signific;mt and positive, indicating higher
charge-off mtes. The nonperforming lo;m r.Hio,
however, was not initially affcxlcd by growth
through merger. The lagged effLoct of growth
through mergers rdiscd Ihe nonperfonlling 10:10
"lIio in the second yem after the merger.
Growth through mergers docs not gcncrate
the initial improvemem eITect ~usc the acquiring
hank is acquiring loans extended by the acquired
hank in previous years. As a result, there is no lag
hetween when these loans arc placed on a bank's
books and when the 10:111 might dcf:lult.
Growth through the acquisition of failed bank..<;
appears to be highly successful in improving ;IsseI
quality only in the short run "11,(: initial and oneyear lagged effects of growth through fai!t..x\-hank
:Kquisition were to lower l)()(h the nonrx:rfomling
loan mtio and the chargc-off ratc. 111C longer lagg{..>(j
t!ffecls were not significJ.ntly different from zero.
Bank size appears to affect 10:111 quality differently, depending on wht:thcr quality is measured
by the nonperforming loan r.llio or the charge-ofr
rate. The positive and significant coefficients on
the total assets variahle (7it) indicate that larger
hanks had higher nonperforming 10:ln mtios, :lnd
these hanks had significantly lower charge-off
rJ.tcs. This result suggests that larger banks may not
'8
be ;IS ;lggressive in charging off nonperfomling
loans ;IS ;lrc small banks. One reason would Ix:
that brge ha nks may havc a competitive advantage
in working out troubll.."<1 credits and, cOIlSl."quently,
carry stich loans <IS nonperfonning longer and
charge off fewer of these loans.
The dfe(.1 of Io:.m portfolio conccntrJ.tians on
loan quality suggests that banks concentmted in
husiness and re:1I eSlate lending were slow to
c harge off nonpcrforrning loans. Troubled rca l
c:state and business loans may be more likely to be
successfully rescheduled and ultimately collected.
If this is the case, these loa ns shou ld Ix: reponed
as nonperfonning :md need not be charged o ff.
Crcdit quality, whe n m(;:asurC<.1 by the chargeoff r.ltc, moved with the busincs.'I cycle, as expected.
Declines in the growth rate:.: of Texas nonagricultural
employment correi:ltl...xi with higher charge-off rates.
In the nonpcrforming r::nio regression. however,
the husiness-cycle v:lriable was nOI significa nt
The regression resuits are:.: .lIso consistent
with the premise th:lt mar.11 hazard contributes to
asset quality prohlems. If moral ha 7~'lrd were prevalel1l , then hanks with low equity would be
more likt:ly to have pUfSW..'d risky strmegies. The
sampk of high-growth hanks was split into twO
groups: hanks willl :Ibove-average equitY-fo-assetS
r.lIio:-. and hanks with bclow-aver..lgc r,nios. Both
high-equity and lo\v-equiry banks showed the
Fedcr.ll Kcsen"t! H.ank of DaUas
Table 4
Regression Results for Moral Hazard Test Using the Charge-off Rate, 1980--90
GROWTHO
GROWTHt
GROWTH2
GROWTH3
EQUITY
GROWTHO )(
GROWTH' )(
GROWTH2 x
GROWTH3 x
EQUITY
EQUITY
EQUITY
EQUITY
- .019935 . ,.
- .006667 •.•
.000110
,000813 ..•
GRO·R
GR t -R
GR2·FL
GR3-FL
-.014355 •••
-.005046 •••
.002012
-.000019
- .176713 •••
.004849 •••
.000010
- .002458 .•
-.000793 ·-'
GRO·FL)(
GRI·FL )(
GR2-FL >c
GR3-FL x
.003305 , ••
.003 181 .••
.002248 '
- .000068
CMLRA T
RLRA T
EMPGROW
Intercept
- .001337
- .000765
.001060
.003831
Adjus ted R 2
Fslalisllc
Observations
EQUITY
EQUITY
EQUITY
EQUITY
-.0565 14 ·-'
-.000836
- .000930
-.042943 ·' ·
-3.745804 •••
TA
GRO-MRG
GR /-MRG
GR2-MRG
GR3·MRG
GRO- MRG )(
GRt ·MRG)(
GR2-MRG )(
GR3·MRG x
EQUITY
EQUITY
EOUITY
EOUITY
.000086
-.000602
- .004156
- .003980
.1920
106.720 . ,.
12.902
• Slgn.lltanl al the 10 level
•• Sign,f,cant at the OS leYet
••• Slglllhcant al lhe Ot leYel
NOTE. EQUITY . 1 tor above·average equity banks and 0 tor below average eqUIty banlls
...;ut ll ' Iil lli.11 dl"I;'('\ or impro\\'l1lt;m i n 11K> eh:U·).!L'T Ill' c h. l r~\· o i l' r:II L':1I IhL" IO\\ -I.'qUlh ·
11,1111, ... rll"',,' w ith a 1.tg ".. nell ..\I the h igh eqlli t~
h,IIl " .... ho\\ L' \ 1.:1"- IIlL"re \\ ;1'" n!f ... i,l!llific;lnl d "f..'<1
"lr r:11..·
Ih;11 r: II"''''(\ I h.., chargl' orr I~ lI l'
\11 :Idd ilion:il Il ·...l o r l hL" I1H )I~ ! 1 haz:lrd ilypOl lw... i .... 11 ...0 ... l1lJ\\" ... 1;' \ idl 'I1U' 0 1 l h i... Ix·had o r A h in:!r)'
\ ;lri:lh \c \\ a... dt:fil1l·d ;l '" l 'q u,1I 1O I fo r :11->0 \'1;, l\"' I~ I ~l' "'qu il },
Po licy impl icatio n s a nd conclus ions
h:lt11- ... .md () fo r I ill' hd o"'-;!Vl'r:I).!l·
l'q l1l1 ~ h~lllk!'> for 11ll' tou l !'>.ullpk In Iht.:' nL"\\'
·w..·. . . . u Ill. 11K> dqx'mknt
\ .lIuhlL'- lh...· (:h;lrgl'---\ ,IT
I~IIL~\\ .1'" rl..·gl"l· ....-.c.'d ag,lIIhl ttw lIldqx:ndl'll[
\ , l ri~I hk'", I rOIll [h...: pr..·\ [( IU'" rq..:r"·"l( Ilh :Ind Ihl"
pHlI.luct (II tIll' hlll;l!"I \.trI;lhll" II I[h 111L' nnTl"nI and
bg.~I..1. i \ ~lhlL'''' 0 1 till.' gro\\ til 1:11 ..· \ ,Iri:thk· ... Till '
rl· ... IIII'- 0 1 thi ... 1..'' ' l ima1l011 ;11'..· p,....·....... nt ..·d in T;,hk-... 1
,ltld 'i. T h .., initial d k ..·1 ""gllifk:Hltl} IO\\l'rl.."(i l llt'
I"..
Im \ ·~.:qlljt ) ban k ... Al high-,,'q u it y IXUlk .., 11ll" lo ngest
1:1,).:).:o.:d d)','c[ \\ ;1.... . n.... i~no llc;l nt T h .... rl..·"ult furl h.... r
... 11(11"01'1'- IhL' rno.:d h M .,l rd h ypot h ..·... I... If a J).Ink
ha';1 1.Irg ..· alllou nt of il'- o w n t'q ll i t ~ L" :>'po!'>l'd to
rbl... il i ... c l r...-ful not 10 10"'.... 1' it;. crl·( lIt " tand:l,.d ,,_
L"1"l: 1l du ring p .... r iod ... of " Iro n,).: g1"O\\ ·th
l h.l rgl'oll r.11"' ;l1 hoth tlw h igh-I.."(llIi1r ban k!'> :Uld
l ilt' I(f\\·...'qlll t ~ h;mk, TIlt.' 1.1).!j.!,,·d d k(l, ill l\\ l ·\l·r.
... I.I.':ll.hl.l m l\ lll(T(';I"l"(lltll" l l ur).:~· · ( ,t f I:I[l'! or 11ll"
f ...... ' ,.(., .... Ik"il'w -
Third (J,,:,rll' r I ')')!
T h..· .... \'id ..'nn · InUll 'I'ex:!!'> b:ln k ... p rL·" ....nt .... d
hcr.., in<lieuc ... I h,lt :1 "1 ,lll ... tiu lly .,ign ilk:1I1t rda li( ltl ... h lp .."I"'I ... I)I;I\\cl..'l1 I, )an gnl\\ [11 :l nd 10:ln
l h:l rJ.!c-off r.1I .." ,Ifl..'r ,I b).: T he!'>e "'lIIpnicd r..' ...u hs
,If..., in agr..·(.:n ll'nt II II h ' IX'l'ihl' ,,:x:lIl1pk'!'> (If r..pid ly
.).:ro\\ tnt-: h:lIlk ... tll:lt ,,'xlx'nl'nn'd dl"di nl"!'> i n loa n
q ualll } .Ind 1..·\l·n tIJ all} f:ll k-d . E\'t:n aff"'r :dlo\\';IIlCl._·
for h ll ... inL''''!'> q d ..· d r...·l 1" ;tnd h:ml- fi n:IIlO:11
... tnll'tllrt". the "'y!'>Il'IIU liL' rd:uion,~ h i p hl·l \\l"\.·n 10:111
,!.,!["(l\\ th ;! [ld (k IL'I·jOr.1I 111).: loan q U :l li t ~ hdd :ummg
T""~I' h;1l1k ...
dlld rl.).: Illl' 1<)1«)...
19
Table 5
Effect of Loan Growth on Charge-off Rates, 19~90
High-Equity Banks'
low-Equity Banks
Period 1
Period 2
n.s.
PerIOd 3
Penod 4
n.s.
•
The ef1ect o! loan growlh Of\ hIgn-equ,ty baro.s is det8fm>r1oEld by addll"\O !he ooellicient from the
GROWTH vanablfl and the coefhcient nom the cross prodUC1 0( GROWTH and EOUITY An F
zero
.,. s.gnolicant at \heOt level.
n.s.--Not s,gmflcant
tesl is used 10 del"fRne i! the sum IS s'On,licantty d<lIerer11lrom
01 lUU!.......·, it would Ix· :.11 o,o.:rgl·n o.: l~d i z:l1ion
to ...I:,to.: thai .'IlY inno.:;lo,(.· in ti ll· loan ).:rowl h roUt·
will k:,d 10 highl'J" dl:'J").:l·-ofi .:1 1...·... 1.0:10 wowth
duml).: ;111 ...•.... onoillic .... xp:.n .. 'u'l i .. 10 Ix' O':xlx·,·,....d
:I ... II )all d""r1t:tnd nK r ...·:,o,(.'", Funll ...·n1ll)rt·. tht'
t·\ido.:rwo.: II1d i<..~ ' h::." th,lt tlli ... rd.ltion ... hip 1ll;1~ not
hold for h:,n k, ,,·itll .lbo\O':-:I\ ...·r..).: ...· o.:qwty-a......o.:t
r.lt il':-' ·1·IH.:n.:fi)r...·.:I ..... ta t...·d .II)()\ ...·. in ... r....;!'-t;'s in
lo:m Wt)\\ 111 I:1Ie ... ;In:: o nl y .1 "ign;1 1 III' IXbsihk
d . .·di n ...·... in 10;111 <lu.Li it }. and :-O Ut h dedinc ... will
not n...'("...':-.....an ly ()(."/: Uf In 0.:, ..... ,: c , .....·
The r....bl'tm ..h ip 1"11..'(\, ...·...·11 ).:1"()\\l h :,nd qual it)
plac...." an :,d d il ,on;1 1 hurd...·n on h:lI1 k otn,o.:r:-. :mel
d,rL·t"!or.. to l1I.m:L~e ).:f(I\\llt l. t!·...·lull~ T he u .. u;iI
nlL"a.. lll\.· ... 0 1 10.111 q U :l1it~ ;0·...· d ,.. IOtwd \\·hen
).:ro\\·lh r:ll ...·.. charlHI:: .\I.II1 :lgt·r.. :tIld din.~nors n ...·l'd
to ;ldj'bl for lhe."",: di... to!1ioTl'i and ",'-"plor...: new
1ll ...'l hod ... to llIeasure ;lnd l"O'111"01 risk . FurlherIllore. d"'·I<..·nnini ng: 1111:: SOlll·(·l' 01 thl' loan g rowth
i......... pt."...-i:t1ly ll11pnrtanl in :1" .............. TIl,l-: ri .. k . A ).:rtIWing ....nmom}".;' s p~clll:lIi\L· huhhk-. ;I .. hift in
1ll;lrk .... t ... h;I l"L·. or:\ pt:rpt'\I:IIt1l1l of fraud Gill all
gen ...'I':.II .... loan growth. 1)\11 I h.... l"L·.. u lts ;'r~ quill'
dilrL'rl'nt fm:Il1y. the rt.''o{lurle ... dL·\ot .... d to markl'l in).: .lIlt! n ...·d ,1 aelmlm ... tr.Llion " ...·...·d 10 Ix' Gu dully
h;l lann·d to pn,:\\.: nt eH'n ).:()(xllo.lIl .. from
b....l·om in).: tro uhk-d :I ..... t:'t ...
n""C HI:-.t! the prt:iimin;II)' l'vido.:m:e suggests
Ih:1I lo:m /--!rowlh b;, deto.:rmll1ant of 10;111 q u ality,
hank l'x;ul1inL'r.- could U.'>C thi.. 1Illilrma tion to Ix'
m or...' dl"t,'\:lh L' in Ihe L'X:lInina\LOn pnx-....:-..... Gn>,,·,h
2.
nI;L} Ix' onl' f:,...·lur ;I 'llollg .....·\ ...·t:,[ [0 t'olbkk·r wlt ....n
.,..:hl'duli n).: tile fl"L"<ILll'nq ' ot .... -.:,nmn:lt ion..... Fu,1lwr1I10rt.'. j.!ro\\ll1m:t}' 1)(," :1 rl·d llig th:1I indic IIL· ...
\\ hidl ;In::I,, of:1 h:ll1k ·., 1)()rlfollo :If" lllo:-o1 i n IWl·d
of ~·\;lI l1 i n:lI,on for l r ...·dl1 tjlultl'· i ...,ut:' ..
Th .... difft:'r...nt approadK'" to gl::nt:r:.lt ing lo .1n
g l"l"\111 I)ad diffo.:r...·nt ...-I"lnl .. till It);ln qtlalil}" A...
",h()\\ \) :llx)'·t:. ex p" nd i rl).: IIIL' I()atl Ix)n folit)
Ihroug h inn...;t ......·d 1....l1d ll1).: 10 llo.:\\" or t::xi"ling
lll .. [OtH .... " to::nd .. 10 unpft" "" lhe dtargc-olf roll ...·
in ilb 1ly. hut 1.:\ .... nlu:t1ly it h.I" :' nt:j.pt i,·c ...-Ikel
( ,tu\\t h throuXh IhL' :'C<jlli"ll ion of f; l iled h:lIlk ..
\\ilh FDIC a."l-.l;II1(""" 1...·..Il[... (0 imp..mL·[o:tn qU:l lity.
Illo.:;' ... ur...·d by ...·,IIll"r I1Olll x-rf() nllin~ loan rat '0" o r
ch:,rg",'-off 1:11 ....... GI"IJ\\ III Ih rou).:h IlIcrgo.:r.- \\·ith
(llllL·r h:l n ks ICJ\\ c rs 1\);111 ( lu:, l it y \\ltclllllo.:a." l lrL"d
hy 11lL' L"ltargl::-off l~'1L". hu( 'h dkct o n (Ill· 110npL"rfol'llting ratio i" 1.. -." , ~· ......I:lin 11' ;1 b:lll k wishL'''
to grow :!Ild 10 im provL' 10:111 quality. ~rowl h
I hrough tlto:! ;Jcqubillon of I:,ikd ha nk.-.. :' ppL';lr.'i
to Ix ' Mllk'rinr to gn)\\ l h lhrough 'lIl::rg ....r Of
lUll"l'. (hi-.. rt'su lt i .. bawd on "l"eX:h hank ing dal :,
fllr :1 p...·riud of r.lJ)Ld b;l llk J.:'"O\\ til follow",'d b y
IlUIllL'rou .. bank bi lt,fo.: ..
T ilc call ....... o f thi~ dllTo.:rl'lKL' l""II.:t\\ ...·.... 11 h:tnk
Ill....rg ...·.. :tnd failL·d ha nk a<<[ui-..i[ion b likdy to Ix:
[ho.: ;,.."i."t:UlC... g in·n h } lh .... FD IC to thc a~·qui r....r
o f :, f:tik d IXlilk T}'PIClliy. th .... FOIC is lihcr. tI in
r...·lIltwing low-qua lil y " ........'" fro m t he Ixx)k!>. o f
f"iled b:lIlks or i n .•liowi n).: tiK' acq uiring h:lIlk [0
rdum low-quality a" .....'I" 10 ,II ...· FDIC :Iftc r th ....
Fede ra l Rese rve Ha nk of Da Uas
acquisition, If hankers are averse to risk, the credit
quality certainty provided by the FDIC would tx·
considered highly valuable.
l1lcsc J"eSlllt.. suggest that there may he a bias
tow;ud banking <,.'on-.olicbtion to take place through
the acquisition of failt..'(/ banks, rather than through
mergers of solvent Ixmks. Even after an acquiring
bank has dt:cidt.'(/ on an acquisition target, it may
delay the acquisition if, in its assessment, the target
bank is likely 10 fail and CJ.n he acquired with the
FDIC removing th~ troubled loons from the current
loan pol1folio. The acquiring bank will trade 01T the
benefit., of current acquisition with the henefit of
greater cn..'(/it qua lity ccrtainty in the future with an
FDIC assistanct! package. Of course, the acquiring
bank also takes the risk of poSSibl y not submitting
the winning bid to the FDI C.
Economk: RI."Vlew - Th.InI Quarter 1992
Such a bias could s low the rate o f m uchneeded consolidation in the ban ki ng industry.
The U.S. banking industry needs banking consolidalion, because it offers onc of the best
approaches to inc reas ing the diversity of bank
portfolios a nd increasing the efficiency in the
p rovis ion of banking services (Clai r, Tucker, and
Siems 199t) It is possible that the rate o f consolidation may be s lowed by the rate at w hich
the FDI C can close fai led ba nks. If FDIC resolution procedures for failed ba nks are slowing the
rate of consolidation, these procedures need to
be reexa mined . The nation's imereSls a re unlikely 10 be served by drawing O UI the process
o r consolid ation
21
References
Clair, Robert '1'. , Paula K. Tucker, and Thomas F.
Siems (991), MRcmoving the Remaining
Barriers to Interstate Banking. ~ Bmlkers Maga+
zine 174 (January/February): 11-17.
Kaufman . George G . (986). "Banking Risk in
Historical Perspcctive,M FecierJ.! Reserve Bank
or Chicago Staff Memoranda, no. SM-86-3
(Ch icago).
Ely, Bert (990), M
Wherc Did All the Money Go?~
(Memorandum prepared at Ely & Company,
Inc., Alexandria, Va. , July 12).
Shiller. Robert J (989), Market Volatility (Cambridge. Mass. : MIT Press).
Kane, Edward J. (985), The Gatben·ng CriSis in
Federal Deposillnsurance (Cambridge. Mass.:
MIT Press).
&iglitz, Joseph E. (990), MSymposium on Bubbles;'
jOllmal of Economic Perspectives 4 (Spring);
13- 18
federal Reserve Bank of Dallas
John K. HUll
Visiting Professor
Arizona Stale UrwefSl!y and
Research Associate
Federal Reserve Bank 01 Dallas
When Will the United States
Grow Out of Its Foreign Debt?
O
nt.: of tht.: most provocllive devt.:Iopmcllls in
thl.: U.S. n'onomy durin}: the I~HO.~ was the
!":.lpid in<.."n:a~..: in nl.:t fOJ"t'i}:n daim~ on U.S. <I$.~ds.
wilh irs I.:ount..:rpan in :1 lar}:t· donlt'~til' trade
ddieit T o .~() r11C oh:-.ervt·r.~. tIlt: heightened pan:
of fordgn acqlli.~ition of U.S. assets wa~ (."Iear
(:'\'idence of an impro\'ed i nvl.:stmcnt (."lirl1:l1c and
so should he rq.:arded a~ :t ~lgn of stfl.:nl-tlh To
othl:l"". howe\·cr. the forell-tn C".lpital inilow!,> were
the re:-.uh of a hro;ld-hased consumptil'n hinge
By ur..l\\"in~ do\\ n wc;t lth to support pre~nt
spending Ic\'d~. U.S. n:.~idl: nl 'i were I.:ompromisin}: their fUhm.: living st:mda rds
In an :lnil..·It;.' in 11K' Scptt!mher 19H9 issue
of J:cOIlOmic }({'I'iell '. I :lrguf..·d that :1 sl!h.~t;mt ia l
portion of the forei}:n ('apit:11 mnows could I>t!
expl:tincd hy C.S demogmphics. During the
19HOs. the hahy IX)()1ll ~l·nL'r..ltion crl::ttl:d large
invcstment dl:lll;tn d~ , yet on'..:red littk' saving to
fin;tncc them This beh:lvior was nonna!. given
the age of the I.:ohorl. howl'\'cr, and so tht! result ing foreiHn carita! inflows held liltk' siHnific;uKt:
for future US living st:lIltl:irds, one W;\y or tht:
o(ht:l". As IlH:mhers of thl' hahy booll1 aged, saving
would ri se. dOl11t's(ic il1\'t..~t!llcnt would drop, and
thl: Unit l!d Statl:,~ would ,~witch from bcing :10
lillrorh::r 10 a net exporter of Glpit:ll l\ly calculations showed th;lt projL'(,:ted shifb in the age
di~trilllltion of I ' S hOUM.'hokb \'-'ere significant
t'nough to raise net c~ lpit:d outnow~ to 3 percent
of t-WY.»S n;lIion;d pnxiuct (G'lP) hy the re:lf 2010
A prindp:11 a,,,sulllption in my earlier analpis
was thai ri~ing U.s. clpi tal {)utnow.~ could llt;.,
:Ihsorllt;.·d by the rl'~t of til t' world without a
dL'(,:line in interl·,~t r.lle,~ In this artit'lI:. 1 consi(kr
tht, rt'a!'oOn:lhlent's,~ of this a~~umption :md reEcon omic K.,\,icw _ Third
QU:loMCr 199Z
I;!valu:lle the accur..ICY of my l'arlit!r projections.
First, 1 look at thl: other major industrialized
counlries to sec if their demographics would
support a rapid turn:lrollnd in the U,S I.::lpital
account. The rL'sults are decidcdly Ilegative.
Although the U,S. population will age significantly
o\'('r the nt!xt sC"er.t1 decades, so will the popu lations of other m:I;<>r trading nations. 111is coincidencc m a~ing ,'>Crves to postpone the dale of
impro\'el11t!nt in tht: U.S. fort!ign invt!stmt!nt
position A silllul;ltion of patterns of C"".lpital flow
bast!d 011 dcmogmphil.: conditions in thl..· United
States, J:lp:m, Genn:IIlY, and the United Kingdom
suggt:.~t ~ that the U,S could remain a net imponer
of C".lpit;tl throughout the 1990s :lOd into the carly
p:1rt of the next century.
Thi .. analysis prob:lbly represents an extreme
among po.~sihl(' olltcomt!s l>inl.:e other factors
afft,,(.'tillg tht! world Glpita1 markt!t over till' next
few dl..'"(.:ade,~ :II'L' likdy to su pport m{her than
deprt:s.~ interest rates I belicve twO to IX' espeCially imp{Jn:l!1l: (J) a more c()mplete intt!gr:ltion
of den'loping countries into tile world capital
markl:t and (2) the transform:nion of centr"lIy
planned ct'onomies into m:lrket economit:s. The
Unitt:d States i~ ;1 young n:l!ion hy the st;lIldards
or the major industrbliz(.'(1 countries, but it is old
1hs alll(;/e lias oenefltad from COI"'l'OOflIs and advice gwen
Oy SlepflCfl P A Brown and Evan F Koat'IIg lowe special
IflasVcS /0 Franl<bn D &1rger for computa/JOllal aSSIStance
, Johrr K HI/IIS a Iotmer setIIOf ~sr and policy advisoI
at rho federal Resave BaM 01 Datlas
rdative to the iI...'ss-(kvdopc.:d world, If. Ihrou~h
internal refonns, (:ollntric.'S such :1.<; Mexico and
Argentina can &:Iin broader participation in the
world capital m;lrkel. their demographics will lead
them to draw capital from the United Slates ;Ind
Olher dc\'elopt. . d (:ounlries.
A second factor th:1I may s ignifka ntly raise
world im'cstme nl dem:lnd over lhe next few
decades is Ihe economic l ibcr::lli:t~tion of Eastern
Europe and the former Soviet Union. Bccall ,~e of
technological isol:llion and distort<.-'{I incentive
structures, a huge fraction of the Glpital st(X'k in
these coulllrit:s is olltmoded and will have to be
modernized or repl:tced The effects could he
dramatic. In a ,~il11u1ated reconstruction of Eastern
Eu rope, where the domestic capital srock is
effectively doubled over the next ten years, I find
that u.s. capital flows rise from -I pern:n! of GNP
at the end of Ihe 1980s 10 I percent of GNP hy
the end of the century. ·111e consequences of a
rccapitali),..:Ilion of the fanner Soviet Union c.:ould
he far greater.
After weighing the:.e ahern:Uh'e considt,:r.llions, 1 remain in gener::l1 agreement with my
earlier conclusion: with the aging of the baby
boom gener.Jtion , the United St:ltes is likely to
become a major capil:11 cxponer by the e nd of
this decade and throughout Ihe early p:lrt of the
next century. This course of events is nOI a given.
however ind<'"'ed , it is incompatihle with Ihl.'
economic envi ronment of the 19BOs, where international capital flows were confined largdy to
• The dora (Of thiS ellicle reler 10 Wesl Germany I:Jefore
unlficllllOfl With Eesr Gcrmeny
, rnrCffJS/ingly. the simulations indICate thaI us capllat In·
flows should have been as large dunng the 1910s as they
were during the 1980s OfficlBleSllf1l8les. on Ihco/hef hand.
date the decllncin U S net for6lgflasselS /0 /tIcear/y 1980s
ThIs dispwlly between rile smulated and mcaWfoo SCfIeS
8dds II new perspat;tIVC to /h(J tH:/tJale on the /YIg1fl eX U S
fOf6I(YIltldebtcdncss rrsdll/OtlBlSl'l8/ySls has emp/1aSJZ9(j
lheemCfJ}cflCeoi fsctOfSdutlfll) /tic /960s, such as the U S
federal OVdQet dellCll. /hal drew fotfJt9f1 CBpltll1 inro the
lklJled Stales It maybcequsl/y important, however. fOlook
for a CessallOfl 01 facrors thaI had resrralflCd C/IPllal.o'l/Jows
dlJrmg /fJ8 19~ Most III"lpOrl8nlin ttusregardmaybe the
dismantilfll) 01 csptlal COtltroiS by Japan and Of/lef map
counUIeS
major Organization of Economic Cooperation and
De"L·lop11lt:nt (OECD) counlric.'s. But the capilal
m:lrkt:1 of tile fUllln::: is likdy to contain many new
players. c:'>flC'd:llly :1 nlltllocr of developing and
newly liher::llizt:.xl countries. ·1111.:' new participants
will Ix: nL"! Ix)m)wers of <.-:Ipital :md so will support
the turnaround in Ihe U.S. clpital account th•• t is
called for hy the aging of thl.! U.S. population.
Demographics a nd capital flows
within OECD countries
A limi\:ltion of the analY1>is in my earlier paper
is that the effects of U S dcmogr.lphics on U.S.
capital outflows werc eval uated in a v:ICUlIm,
without referl'ntl' to demogra phiC condilions in
OIher tnlding cOllntrh:s. In this section, J look
,<;imllltanl.!()u ,~ly :11 the demography of fo ur major
industrialized ('()untnes: the United States, j;Jp;Jn,
GL·nn:my,~ and the United Kingdom, These arc
:lmong thl.! lar~est of the developed cou ntries, and
their demogr.lphk' characteristics are varied e nough
to I'll' n..·prtst:.·ntalivt:: of all OECn countries
The :maIY1>is here i:. ha:>(.-'{I on numerical
solution:. of an over1:lpping gcner::ltions model
:.illlilar 10 the one I uS\...'(1 in my e:lrlicr paper 111e
lll(xlcl is bril'fly descril){.xl in the hox litled 'The
Simulation M(xlt:.'1. The simul:tlions cvalU:lle the
effect of compar::nivc demographics on the nel
external as.<.;tt position of each co untry for each
year from 1970 to 2010. Oernogr.tphic differences
highlighted in the mcxlcl relate to hislorical
variations in tht: size of sucCt.'SSive binh cohons
The analysis ignores :Iny v:lriation in life expectancy or patterns of hOll.';ehold form:ll ion.
The n:su!ts for the decade of Ihe 1980s arc
very ,~ imilar to those r foun d in my earlier work.
When delllogmphic condit ions in the four countries
are tonsidercd together, Ihe United States remains
a net e.lpil:!l imponer. with a current account deficit
aver::Jging 1 perccnt of GN P each year througholLl
the decade. The dominant capital-exporting
country is j ap:m, with annual outflows avcr.lging
3 percent of its GNP. The United SI:lles iS :I nel
recipient of foreign (;:l pilal not beeilise ils savings
r.llC is low hy intern:ttional standards, but beC.lUse
it.. investment r.lte is rcl:llively high. The high rate
of dO/llI.!:>tic investment over Ihis period reflects
the entry of the baby boom gener.llion inlO the
U.s. work force 1
H
Federal Reserve 8ank o r Dallas
The Simulation Model
The model is designed not to replicate
history or to forecast. but to evaluate the
partial effect of demographic conditions on
world capital flows. Households have identi·
cal preferences for consumption over time
and identical life-cycle patterns of labor sup·
ply. Countries produce a sing le good using a
common technology . Simulated movements
in the external asset position of a country are
entirely the result of relative shifts in popula·
tion age mix .
Wealth accumulation . Households are
formed by two adults of age 21 . Each member
has a fixed and known life expectancy. Households accumulate wealth according to the lifecycle theory. Each maximizes a lifetime utility
function containing two parameters: an elasticity of intertemporal substitution and a pure
rate of time preference. Following recent literature , I set the elasticity of substitution at a
low value . The utility function also contains
periodic weights reflecting family needs. These
weights are defined by combining age·specific consumption weights with an assumed
life·cycle pattern of family Size and age com·
position.
Households begin their lives with no
wealth . and they leave no bequests. They
borrow and lend at a single rate of interest on
the basis of their current and future labor
income. Household labor supply is exogenous
but is defined to reflect age-related variations
in labor force participation and worker productivity.
Figure A shows an optimal wealth profile for a given wage and interest rate. The
profile has the traditional hump shape , reflect·
ing a pattern of accumulation during the work·
ing years followed by a reduction in wealth
during retirement. The principal limitation of
Economic Review_Third Qu:u.,c r 1992
Figure A
life-Cycle Profiles of Household Wealth
and Required Capital
. . .......
REqwIOd CIlf"UlI ....• ............
.... ..-........ ..
-.,
.........
\
\
,.......
\
i
"
"
"
Ag.
., !
"
NOTE · Wiltl iii world caPttiil' mar1<ef. reliiltove demogfllPhics
det&ff!'\1f18 the ,nle<fWll tQOii1l investmef1t pMlbOn 01 iii
counbY Young countries become neI debtors bBciiIuse
the CiiIpItal lequ.led 10 support \he,1 wont 1o/Cl!S
e~ceed:r.1tIe aCOJrnuliillec:l weiil~h 01 me.. reslderlts.
Corwerselr . old countlleS become creditors 10 lhe lest
01 \he wofld
the life-cycle model is that it overstates the
rate at which households draw down their
wealth late in life . For some countries , the
share of the elderly in the domestic population
changes significantly over the period of our
analysis. As I will note later, however, the
direction of the bias is clear, and it reinforces
the conclusions ot the analysis.
Capital formation . Each cou ntry produces a
single. nondepreciating good using labor and
the good itself (capital). There are no adjustment costs in capital formation. The capital
stock in a country depends on its labor supply
and current lactor prices.
(Continued on the next page)
"
The Simulation Model-Continued
All types of labor are perfect substitutes, but the efficiency of an individual's
labor varies with age . The assumed eHects
of age on male productivity are based on
studies of age-earnings profiles of U.S. men
with college experience. Earnings for female
workers are assumed to be independent of
age and 1.3 times the earnings of an entrylevel male worker.
Each household generales a demand
for capital that is proportional to its labor
supply. Figure A shows the relationship between age and required capital for a given
wage and interest rate. The shape 01 the
profile during the first half of the life cycle
reflects gains in the productivity of the male
worker and changes in the rate of female
labor force participation associated with child
rearing . Effective household labor supply
peaks when adults are in their early forties.
After that, labor supply begins to declineslowly at first. tracking the decline in worker
productivity , and then more rapidly as labor
force participation falls .
Equilibrium . The real interest rate adjusts to
ensure that aggregate wealth at the beginning of a year is just sufficient to finance
aggregate capital requirements for that year.
The net foreign asset pOSition of a country is
determined by the relative age mix of its
population. Individual household wealth, W,
depends on age, a, and the interest rate, r, but
not on country of origin. The implied capital
requirement of a household, k, is also inde-
26
pendent of its country of origin , varying only
with age and the rate of interest. In equilibrium , therefore, net foreign assets per household in a given country can be written as
NFA = L1p(a) - p ' (a))[w(a,r) - k(a,r)).
•
where p(a) is the fraction of the country's
household population of age a andp'(a) is the
corresponding fraction for the world. Differences in age mix provide the only basis for
international exchange. The net external
asset position of an individual household
rises monotonically with age. Thus, countries
with young populations become net international debtors. TheIr net foreign asset positions increase as they age relative to the rest
of the world.
Demographic data. The model requires information on the number of households living
in each country during the period 1970-2010.
To measure the households formed in a given
country in year t, I divide by 2 the number of
individuals who were of age 37 (the median
age of the statistical age bracket 35-39) and
residing in the country during year (t+ 16).
Individuals are counted in their late thirties as
a crude adjustment for immigration. Population projections are drawn from official sources.
Because the period of analysis ends with the
year 2010, relevant birth rates are known,
leaving immigration as the major source of
uncertainty in the projections,
h'd el'll l ttcsc r n' H;IIlk of Dall",,,
Table 1
Simulated Rates of U.S. Saving, lnvestment, and Capital Outflow, 1990-2009
Ave rage of An nual Rates
(percent)
Macroec onomi c Aggregate
,.......
1990-94
1995-99
2000-04
3.9
44
(3.7)
SA
'.0
(3.7)
(3.5)
Constant World Interest Rat e'
Saving/GNP
(3.9)
Investment/GNP
Capltat Out1lowfGNP
3.9
3.5
30
(2.5)
( 1.7)
(. 9)
20
(.2)
0
(1.4)
.9
(2.0)
24
(2.8)
(3.3)
4.0
Declining World Interest Rate"
Saving/GNP
Investment/GNP
Capital Ou t1lowIGNP
3.9
43
5.3
58
(3.9)
(3,6)
(3.6)
(3.3)
5.3
55
5."
5.3
(3.9)
(3. 6)
(3.6)
(3 ,3)
-1 .2
(0)
(0)
5
(0)
-1 .4
(0)
-.
NOTE Fogures ,n p;lIentheses ilIe macro aggregates for a collectIVe g roup COOlSISMg 01 the UM ed States, Japan. the former West
o.rmany. and the LInII9d Kingdom
'Interest rille held constant at ,ts marl<.et·cteil<ll"lQ vak.le In 1989
"Interest r,lte iId)lIsted eac:n yeill so that capilal liows among the lour mapr countrl8S nel to Ze<O
Pr(lj ...·~·tt..-d C:lpil:\I 110w" for till" lle.\1 t\\O
decllk'.... dlllo..·l gro..·;lIl}". (kpClldill).! on \\ helller int~·r·
l·.~t r~ ltl· ... :11"\.' :1."Mlilled ("OIl.~I:l!lt or :lre :\dlll~t l:d lIntil
Ih)\\, allHlllg Ille fOllt" m~ljor nlllntrk's nI:l 10 1.l"t"O.
Tlw \\\0 C:I ... l'... :Ir~· t'nntr~tst('d in T:lhlt.: I ;lIld I'ig\ll..... ~
IA and III \X' ith a l'Orbt:lf11 intt.'l"l·.... t r:ltl·. tll·1110·
gl~lphlc .... hilb \\'Ithin th l ' t·
poplll:ltiol1 prOdlll'l'
0\ l'r thl' IX'riod ]!)l)()-2009:1 2 p(:rn:mag.... -point rb ....
in lht.· ,:1\ in).!..... r:ltL' :lnd .1 2-pt.·I"t.'I,: ntag.... ·poi1l1 dedi)w
III tIll' !~ t tl' (If lIl\"L·~tll11·llt. :I" .... how!l til T:lhk I
/knmlingly . l · ~ L':l ril~11 outnow .... ri .....· hy Ilx:r(·L·n1;Ij.!t.· poin" ()f G\ I' Thl' I~ :1 fqx'lilion of the
dr:Ull.UK proit·l·l l()n~ cOnl:unl.·d in Illy t.·;trlit.·r ;ulidL'
\1 ;1 nUN.lnt intt'rt'st r:llt.·. the l 'n itL'!:1 St.IIL·~
\\ould 'Cd, 10 n.-duct' il~ ... xt .... rn~11 dd)! Bul thl'
(/{Iwr m.I~)r ("()UmriL"':'> \\ould \\ i~h I() r....1ll.lin Clpit:ll
L"'pot1l·r~. :1. . illdiClIt'd i n Figun.: I B Tht.· re~lI1t is
:1 (':lpil;ll glut. \\ illl :IAAH.·WU", wealth L·\u:cdinj.!
s
Eco n o ll)iC" 1t('\'Io:w -
1"h ird Q uarter 1992
(~'pital detl1:lI1d by ]}lOrl' than 10 Ix:n:l'nl
hy 2010' IIll ....r..."t r.l1e" must fall 10 elju:tlize clpiul
aJ.U.:rq.ptL·
ll()w.s :lllHJn).! lilt,! c()llntri('s Inve... tl!ll·nt slx:nding
i.~ ,,,uhst:lnti:dly mOT .... inl .... re.~t .... bstic tllan saving.
~o til t.· hulk o f th ...· disequilibrium adjustment bIb
011 i1l\l·~lm .... 1lt For tilt.' United Slat l·S. til(: posi ti\'l·
dli:n on ilH"t·.... tlll(: nt from a falling intt.'re"l rate
tlffSl·I.. . tllt.· nL'gati\L' dTe<:1 of :-.lc)\\t.'r lahor force
gro" th . Any rt.'duCl ion III the l~lte of c l pllal inllO\\
The SIZe oJ rho saplu$ '5 prOO801y unde<staled For Japan
aoo Germany. me shale 01 the pooulallOf> age 65 and ONe!
IS PfOfeCled 10 1056 ~llCant/y Iflfooghoor the 19905 aoo
2000s Goven /flat me h/e-cycIe /TIOl1fff OWIfslateS /fie rare 01
d,ssa...ng amotlg theeldt!rly, tna saVlfl9s O\Ie£hang 1$ Wee/}'
10 be even larger I/laIl my anaIysl$ suggests
27
Figure 1A
Figure 1 B
Projected Net Capital Outflow of the
United States: Constant vs. Declining
World Interest Rate
Projected Net Capital Outflow of Other
Selected Industrialized Countries:
Constant vs . Decli ning World Interest Rate
Pelcent of U S GN P
Percent 01 U S GNP
•
•
•
•
,
,
.
.............,.
..
,~
~~~~------------~~~---
.................................................~.;:;:......
......................................01het~ ............. ..
o +----------------····-····~'~~,~_~--
......... .. ..
~
t Japan. Gelman~ , and the United Kingdom. collec1lvety
NOTe , Wilh a constanl world II'It8rlSllall. ml Untied States moves steitdlty toward becoming a large net e~pone' 01 C<lpjlal by the early pall of the
next century Other majOr ,nduSilta lized counlf0e5 WIsh to ,emaln capjtal e~poners. however Without extl,nat invistmeni oppor1unol0e5 to
acc:ommooate these capttal outflows . Ifllerest rales mustlal The drop in rales would 51omuiat8 Iflveslment spendong around lhe world and
delay the date 01 tmplOVlmen! Iflthe U S mtematlonal investment po5OtlOl1
occurs Ix-c:lus.... of an incn::I ~ in till.' s.:1\'inW' rak'
U.S. net foreign a...,se1..., l 'ontinlle to dedine
throughol11 the 1990s and o n into the Iwxt
ce ntUll'.
'111e IXI:">ic n: ason for tht:.'>t: rC:">I1i1s i.'> as follows
The U.s. popubtion w i ll age .~ig nifk:tnlly OWl' the
next two dt:Gtcles, rdlecting the :Iging of till' brg....
[),Iby hoo m cohort. By ihcJf, this :Iging would
produce:l suhst:.llllial ri.~e in the U.S. fort:ign
investment positi()\l I low .... ver. the p()pltlati(JIls of
o ther major industrialized CO llntri e.~ will also ag....
over this period O n b:lbnce, Ihe U.S.-world
median age differt.'nti:tl will ri."\l.· only mod .... r:ttel y
The implica tio n is that any inere;!st: in U.S. net
fort:ign assets \vill Ix: m uch sm al ler than a parti:'l l
an::alysis of U.S. demographic trends would suggest
The demograph ic forces hchind this analysis :.m:
dear and dL'(;isivc, so the conclusions are robust
w ith respect to both alternative par.Lmeter valm:s
in my own :m alysis ;mcl alternative Imxlding
appro aches (Cutler c t :11. , 1990, and M:.I.......o n amJ
Tryon , ] 990).
2.
Dem ograph iCS in developing countries
O n.... of the salienl trl'nds in the intern:u iona l
n'Ono11lY in till' IXI.'>I t1ftl'Cn years has been a move
tlJward f!1'l.':.Hl'r intq..:ration of l1ati(l11al capital
mark .... ts. l ..~ JX·l· ia lly among O ECD countri .... s. If this
trend continuL's. til t: analysis of the previous section
may itself be tl:twed by its o mission of new participants in the world ca pit:11 market Figure 2
indicat .... s how the n.::sllits of the previous analysis
wOl1ld ch:lIl).:o.::. Ikbti vt: to oth .... r developed cOlin·
(rie.... the United States is :l young nation. If capital
tlow.~ :.11'0..' brgdy t;.'(lIlfined to developed countries,
the United Sl ates wil l tend to be a net debtor
nat ion. The m ....d ian age o f the U.S. IXlPulation is
high. hOwL'v.... r . in relatio n to the Icss-develo(X->d
world. Tht: diffcrt:m:e is mocler.ltL' hut Significant
wh .... n comparing the United Simes with the fastgrowing 1::1.~t Asian COlintriL'S, slich as Hong Kong
:Ind Singapore Tht: age differenti:11 is dr:lmatic,
however, in the C:'ISC of Mcxico :md other wtin
Am .... rica n countries. The Ille.s....age, then, is clellr If
Fede ral Reserve Hank o r Dallas
th\.' pnx\.:'S,.. of cap ita] mark\.,t intl;"gI~u itll1 Ctlntinllt".~
a .. 10 ind ll(lc many of Ill\.' dl;"\'dopin,!.: countries.
d .... l1logr.lphic forc ....s will .'>\.'1"\ l' to suppon intert:st
r.Uc!'> and r.lisl· tIl\.' intem:llion;l ] inn:...l l1ll·nt
posillon ... of till' rn :l~)f indu!'>l ri;llized counlries.
ind lldi ng Ihe Un itl·d Si all'!'>.
. .0
Capital demands from newly
liberalized countries
1'"k.·ll1r'Rl':.lpily is nOl. of (·OUTse, Ihe only f:1L1or
I h;1l \\'ill afTn 'l world <:apil:l ] tlows in comi ng
( lcc.I<.Ic... Of p:trtinilar fl'l'l'nt inh,,,r....:-.I arc historic
c.."(.:ollomic reform ... in Ea:-.ll·rn Europl;" To gallgt: Ihc
pOIl'nlial si!-:nificlIl<'v of lilese rcforms. 1 llsed thc
m(xle! (0 simubtl' lill:! dfL'('1 of:1Il ecollol11i(' fI;"COIl :o.\l1.l<.'liOI1 of 1'-::1.0.(\1.:1"11 Europe Fo r purposes of sil11l1 I:Il io n. [ Cft::ll l'd :1 (,Ollntl), gro u r l11at, rL"i:llivC' 10
Ih .... col lL.-cti\'t: ropLI 1alioll o f Ihl:! four major industnaliZ\.'(1 counlril·S. h:l.~ :U1 i<.knl iGl l :I,!.:l· m ix hut h
onl)' o ne fOlln h Illl' :oi"e 10 rdlcct Iht' fl.,bti\'(:: size
of till' six newly lil~I~IIi"l.·d cou ntrit:,.; of Bu lga ri:l.
CZl.·cho.~lo\'ak i a. E:I.~t Gl.·fm:lny, Hungary, Poland.
:md Ihun:mia To .. imulale rt..'('onstnlClion. I
:1....:o.lUlll· 1h:1I thl' capita l ..11M.: k of Iht' counlry group
Simulated Effect of Economic Reconstruction
in Eastern Europe on U.S. Net Capital Outflow
Percenl 01 U S GNP
,
,
,
.............
~
...... ...............e;;;C":'..............
NOTE Economoc relOfms In centrally planned or Iess-ooveloped
market economoes can I'Iave a Slgn,locanl ellect on Ihe U S
capLIII aeoounl Here. reforms Ihat succeed III doubllng!he
East European capital stod<. over a ten·year peliOd rlllse U S
net Cilpllilt ourtkM'$ by 1 plli'cem 10 2 pllfcem of US GNP
at tht: hCj.!in ning of 19<.Xl is only one-half as large
would Ix: o plimal. given Ihl.· ~i%e of it.~ lahor
fofCC' and Ihe prevailing world iml·ccst r.lI .... Rt.."COn~tnl('ti()n consbt.~ of a capital <.h.:ept.'ning that takes
plact: at a uniform !~I\e o\'er :t tt:n-year period
until Ih<.· year 2000. when capilal-I:tbo r 1':.1I10S are
cqu:llizt:d
The cffcrts of thc..: recon'''I1·uction arl:! shmvn
in Figurc..: j. A 111.:1 <il.:Ln:1I1d fo r l.:apil:J1 by E:ISI
Eu rop ....:m counlrie:>: :>:ervl:!S to limit the dcdinl:! in
world interest rall:!s. U.S. (':'pil;iI !lows move from
:I deficit in execs:>: of I Ix.'rcel1t of GNP al Ihe cnd
of IIll." 19HOs to:1 " llrplus o f nl'arl y I pcm;,nl of
GNP hy the l:!!ld of the century Without additional
sti mulll:>:. thl:! U.S. ('Llrrcnl :Jccolint then falls hack
into ddkit. By Ihill lime, howc\'t:r. the fomll:!r
~wil.:l Un ion may Ix: in a position to host fo reign
inn;!stmt:nl . with potcntially grcatt:r conSL.'"quences
for world Glpilal nows
:IS
Figure 2
Median Age 01 Population in 1990 lor Selected
Developed and Developing Countries
'"
'.N
Figure 3
'"
Arg&11I1n1l
-",.
S.-.;Iapor.
~,
".
".
'"
'"
~.
'"
NOTE II ImemallOflaJ borrOWlOg and landing are hmned lo!he
developed world. tllen demographoc forces push lhe Ulllled
Slal&S toward being a debtor ""hon. The UIlIIII(! Stales is mo,e
hkely to be a net aedltor ,t developing counlnes can become
more thoroughly IOlegr,n ed ,nlO lhe world capotat market
F..cono m k Revi.:w - Third Quarter 1992
Does it matter?
A prin<.'ipal lesson o f lhe analysis in my
earl ier p aper W;IS Ihm d cmogr.l pbic shifts GIO
product: large changes in capital flows and other
macroeconomic aggregates that have very little
consequence for living standards. So long as
households plan over their life cycle, does it really
matter whethe r the U.S. international investment
position begins to improve this year or in ten
years' time? There are at least two reasons fo r
believing thai i\ does.
First , a world capital glut would make it
more difficult for members of the U.S. baby boom
to prepare for retirement, adding to whatever
burden recent fiscal policy may have left them.
Even more threatening. however. is the possibility
of rising protectionist pressures should the U.S.
trade balance remain in deficit for another ten
years. In this light, recent economic rcfonns in
Communist nations and in some Latin American
nations, such as Mexico and Chile , take on added
significance. Through their effect on world capital
markets, these refonns may promote equity across
generations of U.S. citizens and help 10 preserve
free international commerce and exchange.
FakraJ Reserve Bank or Da.I.las
References
Cutler. David M., James M . POierba, Louise M.
Sheincr, and lawrence H. Summers (1990),
MAn Aging Socic!y: Opportunity or Cha llenge?"
Brook;IlgS Papers on Economic A ctivity, no.
1:1-73.
Hill , John K. (989), Mlkmogl.1phics and the
Tf3de Balan ce,~ Federal ReselVe Bank o f
Dallas Ecollomic Review, September, 1-11.
Economk: Review - Third Quaner 1992
Masson, Paul R. , and Ralph W. Tryo n (1990),
"Macroeconomic Effects of Projected Popula"
tion Aging in Industrial Countries," IMFStaJ!
Papers, September, 453-86.
li VEST1. TG FOR GlRO\YTB
Thriving in the World .\larketplace
A Conference Sponsored by
the FcdernJ Reserve Bank of Dallas
October 29-30. 1992
The Federal Rcscr ... c B:lnk of Dallas 1992 Southwest Conference will CXI)lorc the
cmcfJ.:ing rea lity o f free tr'Jdc. The move to fre e trade is a watershed event for the
Southwest, \\ hich stands at the l'ross roads ofNonh--Soulh commerce. ' I'he l'On fcrence.
now in ils fi fth yc~u , will feature experts who will discuss ways to ;n\'(:51 for rhe future
and res tructure our economy for maxim um growth in (he new illlcm:ltiurm i m:l rkctplncc.
Speakers Include
• Pedro Aspe, Secretary of Finance,
~Ie)(ico
• Stc ... c Bartlcn. Mayor of Dallas
• Dunald Cuny. Execut;, c Vice P resident. Finance and Pl:l nninf!..
Af\ IR Corp. :lnd American Airlines Inc.
• I .inner De ily, President and Chief Executin: Officer,
Fuse Inll! rstace Bank of Texas, ~.A.
• ~Iihun Goldbc:r,R, Dircccor of Research. U.S. Department o f EdUC'dcion
• Admiral nubby R. Inma n. lIS:-.J (reti red)
•
behOld Lc\y. Publishc: r, Tt'Xm .Ilof//IrI]
• William A. '\;iskancn, Chairman, Cam Institute
• Rolx:n O . ~ l cTce r, Jr.• President and Ch ief Executive omcer,
Fedcml Re~crve Bank of Dallas
• I"bn ey I{ o~cnh l um, Se niOr Vice President :.md Director of Resea rch,
Fe de ral Rese rve Bank of D:l lias
Confc..-cnce Scs!lions
• OvercOllli ng barrie rs
I(J
free tmue
• The im porta ncc of international tr:.ide and growth for the Sou thwest
• RcsHuct urinJt euueatiun to meet the needs of tomorrow's workplace
• Uuild ing an e ffi cicll[ hcalth C'.lrc system
• Importanc reKiona l issues addressed by a panel o f regiona l leaders
Atltliliolllli Infomuuion
The 1992 Somh\\eSt Confercnc.'C will be in the Dallas Fed 's new headquarters, JUSt
nOrlh of WuotIall Rod~er.s Freeway at 2200:'\l.. Pearl St. in tlo\\nto\\n DaIl3S.. The
regist ....,llion fcc is $150 uncil October I. 1992. anti $200 after October I , 1992.
RegislI"onion matcrials will be mailed larer chis su mmer. T o requcst rc~istra( ion
matcriab or more information, callihe Dallas Fed at (2 1") 922-5259.
Economic Key"'..... - ThInS Quane.r 1992
New Dallas Fed Headquarters
In July, [he Federal Reservt! Bank or D-.t ll~ compleled its move
into a new headquarters buildjn~ at 2200 N Pearl St., 1)-.. II:1s. Tex3:.
'n)C m:uling address. Stalinn K, D:llla~ TX 7';222, has not ch..nged
Importanl phone numhcr.. arc the following:
New main number:
Toll-free number:
New main fax number:
(214) 921·('()OO
(800) 333- H('()
(2 14) 922-6500
@FedFRASER