The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
www.clevelandfed.org/research/workpaper/index.cfm
Working Paper 9001
THE DETERMINANTS OF COMMERCIAL BANK HOLDINGS
OF MUNICIPAL SECURITIES: 1985-1988
by William P . O s t e r b e r g
W i l l i a m P . O s t e r b e r g i s a n economist
a t t h e F e d e r a l Reserve Bank o f C l e v e l a n d .
The a u t h o r would l i k e t o thank Robert
Avery, Tom Neubig, and James Thomson
f o r u s e f u l s u g g e s t i o n s , and Kyle Fleming
f o r e x c e l l e n t r e s e a r c h a s s i s t a n c e . The
p a p e r was o r i g i n a l l y p r e p a r e d f o r p r e s e n t a t i o n
a t t h e December 1989 m e e t i n g s o f t h e A l l i e d
S o c i a l Science Association.
Working p a p e r s o f t h e F e d e r a l Reserve Bank
of C l e v e l a n d a r e p r e l i m i n a r y m a t e r i a l s
c i r c u l a t e d t o s t i m u l a t e d i s c u s s i o n and
c r i t i c a l conunent. The views s t a t e d h e r e i n
a r e t h o s e o f t h e a u t h o r and n o t n e c e s s a r i l y
t h o s e o f t h e F e d e r a l Reserve Bank o f
C l e v e l a n d o r o f t h e Board o f Governors o f
t h e F e d e r a l Reserve System.
J a n u a r y 1990
www.clevelandfed.org/research/workpaper/index.cfm
Abstract:
This paper presents an empirical analysis of commercial bank
holdings of municipal securities (munis) from June 1985 through
December 1988, using the FFIEC's Reports of Condition and Income.
While motivated by previous analyses suggesting that a shift from
munis to taxable securities is a primary determinant of the overall
impact of the Tax Reform Act of 1986 on bank profitability, this
paper does not directly analyze the impact of that legislation.
However, the paper modifies the specification of muni demand
employed in previous analyses to consider roles for state pledging
requirements, realization of capital gains or losses, and the
simultaneous provision for loan losses. The results provide some
support for including state pledging requirements, realization of
capital gains and losses, and the loan loss provisions in analyses
of muni holdings.
www.clevelandfed.org/research/workpaper/index.cfm
I. Introduction
The Tax Reform Act o f 1986 (TRA) removed one o f t h e p r i m a r y
i n c e n t i v e s f o r commercial banks t o h o l d m u n i c i p a l s e c u r i t i e s by
i n c r e a s i n g t o 100 p e r c e n t t h e p r o p o r t i o n o f t h e i n t e r e s t e x p e n s e
a s s o c i a t e d with holding municipal s e c u r i t i e s t h a t is disallowed a s a
t a x deduction.
U n t i l 1 9 8 2 , I n t e r n a l Revenue Code 265, which
r e s t r i c t s t h e d e d u c t i b i l i t y o f i n t e r e s t expense a s s o c i a t e d w i t h
t a x - e x e m p t s e c u r i t i e s , was g e n e r a l l y n o t a p p l i c a b l e t o t h e a c c o u n t s
i n c u r r e d by f i n a n c i a l i n s t i t u t i o n s t o d e p o s i t o r s . The Tax E q u i t y and
F i s c a l R e s p o n s i b i l i t y Act o f 1982 e s t a b l i s h e d a m e c h a n i c a l
d i s a l l o w a n c e r u l e , a l l o c a t i n g i n t e r e s t expense t o t a x - e x e m p t s i n
proportion t o t h e i r share i n the financial i n s t i t u t i o n ' s t o t a l
assets.
I n i t i a l l y , t h e amount o f t h e expense a l l o c a t e d t h a t w a s
d i s a l l o w e d was 1 5 p e r c e n t , b u t t h a t amount was i n c r e a s e d t o 20
p e r c e n t i n 1984.
1
The e x t e n t t o which banks have s w i t c h e d from t a x - e x e m p t t o
t a x a b l e s e c u r i t i e s i s a p r i m a r y f a c t o r i n d e t e r m i n i n g t h e impact
t h a t TRA h a s h a d on bank p r o f i t a b i l i t y . The s w i t c h t o t a x a b l e
s e c u r i t i e s s u b j e c t t o a lower m a r g i n a l c o r p o r a t e t a x r a t e c o u l d
b o o s t a f t e r - t a x p r o f i t s i n s p i t e o f changes t o t h e t a x c o d e , s u c h a s
r e c a p t u r e o f l o a n l o s s r e s e r v e s , t h a t would t e n d t o d e c r e a s e
after-tax profits.
I n f a c t , a t l e a s t t h r e e s t u d i e s conducted with
pre-TEU d a t a (Neubig and S u l l i v a n [ 1 9 8 7 a , 1987b1, O ' B r i e n and
Gelfand [ 1 9 8 7 ] ) c o n c l u d e d t h a t TEU would improve bank a f t e r - t a x
profits.
The i n f l u e n c e o f TRA on t h e m u n i c i p a l bond market h a s o t h e r
dimensions.
For e s a m p l e , much r e s e a r c h on t h e m u n i c i p a l bond market
www.clevelandfed.org/research/workpaper/index.cfm
h a s f o c u s e d on t h e i s s u e o f whether banks a r e ( o r h a v e e v e r b e e n )
t h e m a r g i n a l h o l d e r s o f m u n i c i p a l d e b t ( f o r example, S k e l t o n
119831).
Even i f s e l l i n g p r e s s u r e emanating from commercial hanks
may now i n f l u e n c e m u n i c i p a l bond y i e l d s , t h e r e now seems t o be a
c o n s e n s u s t h a t banks a r e n o t t h e m a r g i n a l i n v e s t o r s .
I n t h i s p a p e r , u t i l i z i n g b a l a n c e - s h e e t d a t a from t h e F e d e r a l
F i n a n c i a l I n s t i t u t i o n Examination C o u n c i l ' s R e p o r t s o f C o n d i t i o n and
Income ( " c a l l r e p o r t s " ) , we a n a l y z e t h e b e h a v i o r o f commercial bank
h o l d i n g s o f m u n i c i p a l d e b t from June 1985 t h r o u g h December 1988.
However, we do n o t d i r e c t l y s t u d y t h e o v e r a l l impact o f TRA on bank
p r o f i t a b i l i t y o r s e e k t o d e t e r m i n e whether banks a r e t h e m a r g i n a l
h o l d e r s o f m u n i c i p a l d e b t . R a t h e r , we a r e i n t e r e s t e d i n a n a l y z i n g
t h e f a c t o r s d e t e r m i n i n g t h e p o r t f o l i o b e h a v i o r o f commercial b a n k s .
S e c t i o n I1 summarizes r e s e a r c h on commercial bank b e h a v i o r i n
t h e m u n i c i p a l bond market and s e c t i o n I 1 1 d i s c u s s e s t h e
s p e c i f i c a t i o n o f t h e model.
S e c t i o n 1 V p r e s e n t s t h e model, and
s e c t i o n V d e s c r i b e s t h e d a t a . S e c t i o n V I d e s c r i b e s t h e econometric
p r o c e d u r e and r e s u l t s . S e c t i o n VII c o n c l u d e s .
11. R e l a t e d R e s e a r c h
A. R e l a t i v e Yields
Most r e s e a r c h on t h e m u n i c i p a l bond market h a s f o c u s e d on t h e
d e t e r m i n a n t s o f t h e r e l a t i v e y i e l d s between t a x - e x e m p t and t a x a b l e
debt.
I n t h e o r y , t h e tax-exempt y i e l d d i v i d e d by t h e comparable
t a x a b l e y i e l d s h o u l d e q u a l 1 minus t h e e f f e c t i v e m a r g i n a l t a x r a t e .
However, t h e mechanism t h a t would e n s u r e t h i s h a s b e e n a n o b j e c t o f
much r e s e a r c h .
According t o t h e "bank a r b i t r a g e " h y p o t h e s i s , t h e
www.clevelandfed.org/research/workpaper/index.cfm
r e l e v a n t mechanism i s t h e b u y i n g and s e l l i n g o f m u n i c i p a l d e b t by
commercial b a n k s .
Banks were t h e r e l e v a n t b u y e r s o f m u n i c i p a l d e b t ,
s i n c e they could deduct a p o r t i o n of t h e i r i n t e r e s t expense
a t t r i b u t a b l e t o c a r r y i n g municipal d e b t .
I n M i l l e r ( 1 9 7 7 ) , t h e d i s t r i b u t i o n of n e t w e a l t h among
i n v e s t o r s i n d i f f e r e n t t a x brackets determines t h e aggregate
c o r p o r a t e d e b t - t o - e q u i t y r a t i o and t h e e f f e c t i v e m a r g i n a l t a x r a t e s
f o r c o r p o r a t e d e b t and e q u i t y .
The y i e l d on m u n i c i p a l d e b t must b e
s u c h t h a t a l l i n v e s t o r s ( o t h e r t h a n t h o s e who p r e f e r c o r p o r a t e d e b t )
a r e i n d i f f e r e n t between e q u i t y and m u n i c i p a l d e b t .
As Poterba
(1989) h a s p o i n t e d o u t , M i l l e r (1977) i m p l i e s t h a t changes i n
p e r s o n a l t a x r a t e s s h o u l d a f f e c t r e l a t i v e y i e l d s w h i l e "bank
a r b i t r a g e " i m p l i e s t h a t t h e r e s h o u l d be no e f f e c t .
Poterba presents
e v i d e n c e t h a t p e r s o n a l t a x changes i n f l u e n c e r e l a t i v e y i e l d s s o t h a t
a n e x c l u s i v e f o c u s on bank demand i s i n d e f e n s i b l e i n a s t u d y
a t t e m p t i n g t o e x p l a i n r e l a t i v e y i e l d s ( s e e a l s o Fortune [ 1 9 8 8 ] ) .
B. Banks a n d T a x e s
Kimball (1977) d e s c r i b e s t h e i n f l u e n c e o f t h e t a x code on
commercial bank demand f o r m u n i c i p a l s e c u r i t i e s ( m u n i s ) .
From
s t u d y i n g t h e 1972-1975 p e r i o d , Kimball c o n c l u d e s t h a t l a r g e banks
r e l i e d more on n o n - t a x - e x e m p t s h e l t e r s t h a n s m a l l b a n k s , f o r whom
t a x - e x e m p t s were t h e p r i n c i p a l s o u r c e o f a f t e r - t a x income. A s a
r e s u l t , t h e c o r p o r a t e t a x r a t e change i n 1975 a p p e a r e d t o have h a d a
l a r g e r impact on small b a n k s .
L e a s i n g and f o r e i g n t a x c r e d i t s i n
p a r t i c u l a r were s h e l t e r s dominated by t h e l a r g e r b a n k s .
Neubig a n d
S u l l i v a n (1987b) f i n d s i z e t o be s i g n i f i c a n t when e n t e r e d a s a proxy
for tax shields.
However, i n t h e i r s i m u l a t i o n s t u d y , G e l f a n d and
www.clevelandfed.org/research/workpaper/index.cfm
OfBrien (1987) find no size-related differences in the response of
banks to TRA.
The principal determinant of banks' holdings of municipal bonds
seemed to be total income that could not be sheltered with
deductions and credits (see Hendershott and Koch [1980]).
This
seemed consistent with other studies, which concluded that banks
paid much less in taxes than nonfinancial institutions.
It seemed
that banks could drive tax payments toward zero by purchasing
taxable investments to exhaust credits and deductions, then
investing the remaining available funds in tax-exempts. Possibly in
response to these conclusions and to the difficulty in enforcing IRC
Section 265 (which limited deduction of interest expense), TRA
removed banks' ability to deduct a portion of the interest expense
attributable to carrying municipal bonds.
C. TRA's Impact on Banks
TRA's impact on banksf holdings of munis involves more than
just the removal of interest deductibility for the bulk of municipal
bonds.
By changing the tax provisions regarding the treatments of
loan loss reserves, the alternative minimum tax, investment tax
credit, foreign tax credits, and the statutory tax rate, TRA
influenced banksf calculations of the amount of taxable income that
could be sheltered by means other than munis.
In effect, these
changes alter the "break-even yield ratio" with which banks must
compare actual relative yields.
In addition, relative yields have
moved significantly since TRA.
Both Neubig and Sullivan (1987a, 1987b) and Gelfand and O'Brien
(1987) conclude that the recapture of bad debt reserves under TRA
.
www.clevelandfed.org/research/workpaper/index.cfm
will be the most significant impact of TEU on after-tax profits of
commercial banks.
Prior to TEU, under rules determined by Congress,
banks could deduct increases in allowable bad debt reserves.
Post-TRA, banks with assets over $500 million can deduct charge-offs
net of recoveries but will also have to recapture existing loan
loss reserves into taxable income, generally over a four-year
period.
The calculation of the alternative minimum tax also affects
muni demand, since the alternative tax rate has been increased from
15 percent to 20 percent and the base has been expanded.
Half of
reported book income over the alternative mimimum tax is now
included as a preference item. O'Brien and Gelfand conclude that,
for banks subject to the alternative minimum tax, "tax-exempt"
income will be taxed at an effective 10 percent rate.
The repeal of the investment tax credit, effective January 1 ,
1986, and the reduction in the tax shield provided by leasing and
depreciation would be expected to decrease the value of such
activities to banks.
In addition, TRA has reduced the value of
foreign tax credits by restricting the extent to which foreign tax
credits from different countries can be pooled against U.S. tax
liabilities.
Both Gelfand-O'Brien and Neubig-Sullivan point out that
relative yields are not likely to make the purchase of new munis
attractive to banks.
The only exception may be "qualified-new
issues," which retain a 20 percent disallowance. However, such
issues are limited to issuers who expect to issue less than $10
million in one year.
www.clevelandfed.org/research/workpaper/index.cfm
D. Regional Differentials and Supply Factors
Kidwell, Koch, and Stock (1987) have documented regional yield
differentials in the municipal securities market.
The existence of
state pledging requirements was one factor explaining the
differentials. A variety of regulations have governed financial
relations between state and local governments and financial
institutions. General revenues of state and local governments often
must be deposited in banks within the same state. Banks must then
hold municipal securities of the same state as collateral against a
portion of such deposits. The required ratio between the collateral
and the deposits varies from state to state.
In addition, the
requirements for state funds may differ from the requirements for
funds of political subdivisions; the requirements may be different
for "problem" banks; the requirements may differ for banks with
deposits exceeding a specified proportion of capital; banks within a
state may be allowed to pool assets pledged as collateral; or banks
may have to hold collateral against all deposits of the state, not
2
just the uninsured portion.
Apparently in response to research showing that such
regulations were reflected in the costs of state and local finance,
the Advisory Commission on Intergovernmental Relations (1977)
recommended that states reduce pledging requirements.
It is unclear
if the impact of such requirements on the municipal bond market has
diminished. One of the rationales for increasing the federal
deposit insurance ceiling from $ 2 0 , 0 0 0 to $ 4 0 , 0 0 0 was to reduce
effective pledging requirments.
www.clevelandfed.org/research/workpaper/index.cfm
The t a x t r e a t m e n t o f c o r p o r a t e income a l s o d i f f e r s among
states.
More t h a n j u s t t h e r a t e s c h e d u l e s v a r y .
There may be
d i f f e r e n c e s i n whether t h e f e d e r a l t a x b a s e i s u t i l i z e d , whether
t h e r e i s a minimum t a x r u l e , whether t h e r e i s a d i f f e r e n t r a t e f o r
f i n a n c i a l i n s t i t u t i o n s , o r whether t h e r e i s a t a x on t o t a l c a p i t a l
o r a s s e t s . 3 Forbes and Leonard (1984) concluded t h a t s t a t e t a x
d i f f e r e n t i a l s were s i g n i f i c a n t d e t e r m i n a n t s o f y i e l d d i f f e r e n t i a l s .
E.
Timing o f C a p i t a l Loss R e a l i z a t i o n
S i n c e c a p i t a l g a i n s and l o s s e s a l s o i n f l u e n c e t a x a b l e income,
f a c t o r s t h a t i n f l u e n c e r e a l i z a t i o n independently of gross purchases
may i n f l u e n c e t h e n e t change i n t h e muni p o r t f o l i o .
Although i t i s
c l e a r l y p o s s i b l e f o r a bank t o r e a l i z e g a i n s o r l o s s e s and t o keep
muni h o l d i n g s c o n s t a n t w i t h new p u r c h a s e s , t h e new bonds may n o t
b r i n g t h e same t a x b e n e f i t s a s t h e o l d bonds.
Neubig and S u l l i v a n
(1987b) a t t e m p t t o t a k e a c c o u n t of t h e m a t u r i t y s t r u c t u r e o f t h e
e x i s t i n g muni p o r t f o l i o s i n t h e i r a n a l y s i s of t h e impact o f TRA.
However, w h i l e i n f o r m a t i o n a b o u t m a t u r i t y would be v a l u a b l e i n
d e t e r m i n i n g t h e maximum l o s s o r g a i n s t h a t c o u l d be r e a l i z e d , i t i s
u n c l e a r whether t h e r e a r e f a c t o r s t h a t i n f l u e n c e l o s s r e a l i z a t i o n
t h a t a r e not incorporated i n t o r e l a t i v e yields.
I n f a c t , Heaton
(1986) shows how t h e r e l a t i v e y i e l d on municipal bonds i s i n f l u e n c e d
by t h e a s s o c i a t e d v a l u e o f t a x d e d u c t i o n s , and C o n s t a n t i n i d e s and
I n g e r s o l l (1984) e x p l i c i t l y model t h e i n f l u e n c e o f t a x - t i m i n g
o p t i o n s on t h e e q u i l i b r i u m p r i c e s of bonds, such a s m u n i c i p a l s .
C o n s t a n t i n i d e s and I n g e r s o l l (1984) conclude t h a t " . . . t h e main
d i f f e r e n c e between t h e o p t i m a l t r a d i n g p o l i c i e s f o r m u n i c i p a l and
-
www.clevelandfed.org/research/workpaper/index.cfm
taxable bonds is that no (municipal bond) trades are ever made at a
price above par. . . " (p.334).
4
However, when municipals are a t a -
deep discount, their tax-timing options are roughly equal to those
on taxable instruments. In addition, tax timing options, which
should be reflected in relative yields, also vary with tax rates on
coupons and capital gains or losses.
F. Simultaneity with Loan-Loss Provisions
The net income earned on municipals is only one component of
net income.
Over our sample period, provision for loan loss has had
a significant influence on net income. Greenwalt and Sinkey (1988),
in a study of bank holding companies from 1976 to 1984, find
evidence that loan loss provisions were made in a manner consistent
with the income-smoothing hypothesis.
In addition, TRA affected net
income by requiring large banks to recapture outstanding loan loss
reserves. While there are other influences on net income, these
factors suggest that we consider the choices of municipal bond
5
holdings as made simultaneously with loan loss provisions.
111. Specification of the Estimating Equations: Issues
Previous analyses of bank demand for municipal securities
emphasized the role of expected income and tax shields. Neubig and
Sullivan (1987b) develop in detail the banks' portfolio decision
under the certainty case.
For banks that face the regular tax, the
relative yield between tax-exempt and taxable securities (ry) must
be compared to the break-even ratio (byr), which is calculated as
(1) 1
-
u[l-b(id/it)], where
www.clevelandfed.org/research/workpaper/index.cfm
i
d
=
interest expense/assets,
b
=
percentage interest expense disallowance,
u
=
marginal corporate tax rate, and
=
interest rate on taxable investments.
i
t
If the relative yield exceeds the byr, the optimal
share of assets held in municipals is calculated as
(2) MAX( 0 , 1-[i (1-afb)-noif+(c/u)]/it 1 , where
d
af
=
percent of total assets subject to interest expense
disallowance,
noif
=
net taxable noninterest income/assets, and
c
=
tax credits/assets.
Equation (2) is consistent with the insight of Kimball (1977).
Muni demand is positively related to taxable investment returns, net
non-interest income, corporate marginal tax rates, and the
disallowance rate (as'long as a higher disallowance rate does not
increase the byr above the relative yield).
Demand is negatively
related to interest expense rates and available tax credits.
Several problems arise in applying this framework.
First, the
appropriate yield calculation is more complex during our sample
period.
Second, in constructing our measure of income, we need to
consider the possibility that the demand for munis occurs'
simultaneously with other portfolio choices. Third, lack of
suitable tax information prevents us from calculating satisfactory
measures of ex-ante effective tax rates, deductions, and credits.
www.clevelandfed.org/research/workpaper/index.cfm
The comparison o f r e l a t i v e y i e l d s t o b y r s i s c o m p l i c a t e d by
t h e i n t r o d u c t i o n o f t h e new a l t e r n a t i v e minimum t a x ( a r n t ) , which
a l t e r s the byr c a l c u l a t i o n .
Determining e x - a n t e which banks w i l l
f a c e t h e amt i s i n f l u e n c e d by t h e f a c t t h a t t h e p r o b a b i l i t y o f
f a c i n g t h e amt i s i n f l u e n c e d by municipal h o l d i n g s , s i n c e tax-exempt
income e n t e r s t h e amt c a l c u l a t i o n .
Banks t h a t do f a c e t h e amt would
be expected t o h o l d fewer m u n i c i p a l s , s i n c e t h e i r g r e a t e r t a x
l i a b i l i t y would be matched w i t h t a x a b l e income.
I n t h e c a s e p r e s e n t e d above, t h e r e would appear t o be no r o l e
f o r r e l a t i v e y i e l d s t o i n f l u e n c e muni demand i f t h e b y r exceeded t h e
yield ratio.
However, w i t h u n c e r t a i n t y about t a x r a t e s , d e d u c t i o n s ,
o r c r e d i t s , banks may s t i l l purchase munis even i f t h e r e l a t i v e
y i e l d l i e s below t h e b y r . On t h e o t h e r hand, Hendershott and Koch
(1980) c l a i m t h a t a s l o n g a s r e l a t i v e y i e l d s a r e h i g h enough,
v a r i a t i o n i n r e l a t i v e y i e l d s i s not l i k e l y t o i n f l u e n c e demand.
If
TRA i n c r e a s e d b y r s enough t h a t bank purchases of munis a r e no l o n g e r
j u s t i f i e d , v a r i a t i o n i n t h e d i f f e r e n c e between t h e r e l a t i v e y i e l d
and t h e b y r can o n l y i n f l u e n c e muni h o l d i n g s by i n f l u e n c i n g
d e c i s i o n s about r e a l i z a t i o n of c a p i t a l g a i n s o r l o s s e s .
Over o u r sample p e r i o d , r e l a t i v e y i e l d s r o s e i n p a r t because
TRA d e c r e a s e d bank demand f o r munis by i n c r e a s i n g t h e break-even
ratio.
The d e c l i n i n g bank demand f o r munis i n f l u e n c e d p r i c e s and
thus y i e l d s .
However, banks c l e a r l y i n c r e a s e d t h e i r muni p u r c h a s e s
a t t h e end o f 1985 i n o r d e r t o g r a n d f a t h e r t h e p a r t i a l i n t e r e s t
deductibility.
Our measure of expected t a x a b l e income can be o b t a i n e d a s a
f u n c t i o n of lagged income (Hendershott and Koch [ 1 9 8 0 ] ) o r
www.clevelandfed.org/research/workpaper/index.cfm
calculated with ex-post income data, reconstructing a before-tax
income measure from net after-tax income and appropriate
balance-sheet components. Limited information about taxes,
deductions, and credits appears on the call reports. Previous
research has included size as proxy for reliance on non-debt tax
shields. Large banks may be more likely to utilize tax shields such
as investment tax credits, depreciation deductions, foreign tax
credits, and leasing.
IV. The Econometric Model
The model we use to analyze the behavior of commercial bank
holdings of municipal securities from December 1984 to December 1988
uses the following equations:
(3) BVMt
(4) P
(5) R
=
BVMt-l + Pt - Rt;
=
P [ MAX( O,gti 1 , MAX( 0,ry-byr ) , State and
=
Deposits ] + e ,
P
R [ MAX( 0,gti 1 , State and Local Deposits, Unrealized
Local
Capital Losses on Municipals, Other Unrealized Losses,
Loan Losses Provisons ]
(6) LLP
=
L [ MAX( 0,gti
),
+ er '
Capital to Asset Ratio (excluding Loan
Loss Reserve), Nonaccruing and Past-Due Loans, Net
Charge-Offs, Loan Loss Reserve]
where BVM
P
=
-
+
book value of municipal securities,
purchases of municipal securities,
R
=
sales of municipal securities,
LLP
=
provision for loan losses, and
e
1'
www.clevelandfed.org/research/workpaper/index.cfm
gti
"grossed-up taxable income" as described below; e
e
p' r'
and e are disturbances.
1
=
Implicit in this model is a distinction between factors that
determine purchases of munis (equation [4]) and those factors that
influence sales (equation [ 5 ] ) . Previous analyses of muni holdings
suggest that the purchases are influenced by income and relative
yields. We include state and local demand deposits as a proxy for
state pledging requirements. Our formulation of the relative yield
term removes the influence of variation in the difference between
relative yields and the byr on purchases when that difference is
negative.
This forces variation in relative yields to influence
muni holdings through changes in the market value of the existing
securities portfolio (equation [5]).
The realization of losses or gains influences net income.
In equation (5), we distinguish between losses that could be
realized on munis and those that could be realized on other
securities.
The level of state and local deposits would be expected
to restrict the ability of banks to sell munis.
The amount of
taxable income that could be sheltered with various deductions
should be expected to be positively related to loss realization and
loan loss provisions, which are a deduction for book income
7
purposes.
As an alternative to the assumption imposed in equations (4)
and ( 5 ) , which states that the factors influencing sales are
different from those influencing purchases, we consider the
8
following version of those equations.
www.clevelandfed.org/research/workpaper/index.cfm
(4A)
P
=
[ MAX ( 0 , g t i ) , r y - b y r , S t a t e and Local D e p o s i t s ]
(5A)
R
=
[ MAX ( 0 , g t i ) , r y - b y r , S t a t e and Local D e p o s i t s ,
Loan Loss P r o v i s i o n s ]
+ e
P
,
+ er .
E q u a t i o n ( 6 ) s t a t e s t h a t l o a n l o s s p r o v i s i o n s , which r e d u c e n e t
income, a r e i n f l u e n c e d by t a x a b l e income and f a c t o r s d e s c r i b i n g t h e
l o a n p o r t f o l i o o f t h e bank.
The f a c t o r s t h a t i n f l u e n c e l o a n l o s s
provisions a r e c l o s e l y r e l a t e d t o those t h a t influence the a d d i t i o n
t o t h e l o a n l o s s r e s e r v e , a component o f t h e primary
capital-to-asset ratio.
The h i g h e r t h e l o s s r e s e r v e o r t h e primary
r a t i o , t h e l e s s need t h e r e i s t o add t o t h e r e s e r v e . On t h e o t h e r
hand, t h e h i g h e r t h e i n v e n t o r y of "bad l o a n s " t h a t need t o b e
c h a r g e d o f f , t h e more l i k e l y t h e bank w i l l p r o v i d e f o r l o s s e s .
I m p l i c i t i n t h e model i s a s w i t c h between regimes.
The
o l d regime i s one i n which r e l a t i v e y i e l d s and income determined
muni h o l d i n g s .
The second regime i s one i n which r e l a t i v e y i e l d s
a r e n o t h i g h enough t o j u s t i f y muni h o l d i n g s , and, g i v e n t h e l e v e l
a l r e a d y p u r c h a s e d , ' t h e change i n t h e l e v e l i s determined by f a c t o r s
such a s l o a n l o s s p r o v i s i o n s , u n r e a l i z e d l o s s e s on o t h e r s e c u r i t i e s ,
book l o s s e s on munis, and income t h a t t h e bank h a s a v a i l a b l e t o
absorb c a p i t a l l o s s e s .
U n f o r t u n a t e l y , t h e r e i s no d i s t i n c t s h i f t between r e g i m e s ,
s i n c e TRA was a n t i c i p a t e d w e l l b e f o r e i t became e f f e c t i v e .
This is
e v i d e n t i n t h e runup i n bank p o r t f o l i o s o f munis i n 1985.
This a l s o
implies t h a t f a c t o r s determining t h e r e a l i z a t i o n of c a p i t a l l o s s e s
may e x p l a i n muni p u r c h a s e s p r i o r t o TRA.
In addition, since
www.clevelandfed.org/research/workpaper/index.cfm
qualified small issues may still be attractive purchases for some
banks, purchases may occur even if aggregate relative yields are
inadequate.
We specify a two-equation model with the net change in the muni
holdings and loan loss provisions as the simultaneous variables. To
distinguish factors that should influence the level of munis from
those that should influence the change in the level, we
first-difference the former and the dependent variable. We also
specify an alternative version of this system, derived from (4A) and
(5A) .
(7) (1-L)BVMt
=
am
+ bml*(I-L)MAX[O,ry-byrIt + bm2*(l-L)MAX[O,gti]
+
*(l-L)State
bm3
and Local Depositst
+
bm4*(1-L)Unrealized
+
bm5*Unrealized Losses on Munis
+
bm6*Loan Loss Provisions
t
Losses (except munis) t
+
t-1
u
mt '
(8) Loan Loss Provisions
t
=
al + bll*MAXIO,gtil
+
b12*Primary Capital (except LLR)t-1
+
b13*(Nonaccruing+Past
+
b14*Net C h a r g e - O f f ~ ~ ~ ~
+
b15*Loan Loss Reserve(LLR)
Due Loans)
t-1
+
t-1
e
It'
L is the first-difference operator. All variables except
(1-L)MAX[O,ry-byrIt are scaled by consolidated bank assets at the
beginning of the period (dated t-1)
www.clevelandfed.org/research/workpaper/index.cfm
V . D e s c r i p t i o n o f t h e Data:
We choose a l l banks r e p o r t i n g on a l l c a l l r e p o r t s from December
1984 t o December 1988. Omitting banks w i t h s u s p i c i o u s d a t a l e a v e s us
w i t h 1 2 , 0 3 5 b a n k s . U t i l i z i n g t h e June and December c a l l r e p o r t s and
f i r s t d i f f e r e n c i n g l e a v e s u s w i t h e i g h t o b s e r v a t i o n s f o r each bank.
The v a r i a b l e g t i , g r o s s e d - u p t a x a b l e income, i s c a l c u l a t e d
s t a r t i n g from e n d - o f - p e r i o d income b e f o r e t a x e s and e x t r a o r d i n a r y
items.
To t h i s we add 1 ) an e s t i m a t e of t h e amount by which income
would have been h i g h e r w i t h tax-exempt income i n f l a t e d t o a t a x a b l e
l e v e l ( t h e t o t a l of a l l tax-exempt income items [ s e c u r i t i e s , l o a n s ,
and l e a s e s ] was m u l t i p l i e d by [ ( l / r y ) - 1 1 , where r y i s d e s c r i b e d
b e l o w ) , 2) t h e l o a n l o s s p r o v i s i o n , 3) r e a l i z e d c a p i t a l g a i n s and
l o s s e s on t h e s e c u r i t i e s a c c o u n t , 4) t h e n o n - d e d u c t i b l e p o r t i o n of
i n t e r e s t expense a s s o c i a t e d w i t h munis, 5) n e t c h a r g e - o f f s , and 6)
t h e r e q u i r e d r e c a p t u r e of b a d - d e b t r e s e r v e s by l a r g e banks.
A l l banks w i t h a t l e a s t $500 m i l l i o n i n t o t a l a s s e t s a t t h e end
of 1986 r e c a p t u r e a t l e a s t 10 p e r c e n t of t h e December 1986 l o a n l o s s
r e s e r v e i n t o 1987 income, w i t h e q u a l p o r t i o n s i n each h a l f o f t h e
y e a r . I f r e c a p t u r e o f 10 p e r c e n t s t i l l l e a v e s t h e bank w i t h g t i
below 0 f o r t h e y e a r a s a whole, t h e n t h e bank r e c a p t u r e s enough t o
reach 0 , i f t h e loan l o s s reserve is s u f f i c i e n t .
A l l banks t h a t
r e c a p t u r e i n 1987 r e c a p t u r e 2/9 of t h e remainder i n 1988 income.
A
bank t h a t i s n ' t l a r g e enough a t t h e end of 1986 may be l a r g e enough
a t t h e end of 1987.
The v a r i a b l e r y i s measured a s t h e r a t i o between 1 0 - y e a r munis
and T r e a s u r y bonds.
The v a r i a b l e b y r , t h e break-even r a t i o , i s
www.clevelandfed.org/research/workpaper/index.cfm
c a l c u l a t e d d i r e c t l y from e q u a t i o n ( 1 ) u s i n g t h e marginal c o r p o r a t e
t a x r a t e , t h e d i s a l l o w a n c e r a t i o (which i n c r e a s e d from .20 t o 1 . 0
a f t e r August 7 , 1986 f o r " n o n - q u a l i f i e d b o n d s " ) , i n t e r e s t
e x p e n s e / t o t a l a s s e t s a s r e p o r t e d by t h e bank, and t h e 1 0 - y e a r
Treasury r a t e .
For s t a t e and l o c a l d e p o s i t s , we use demand d e p o s i t s of t h e
s t a t e s and p o l i t i c a l s u b d i v i s i o n s r a t h e r t h a n t h e b r o a d e r measures
o f t o t a l t r a n s a c t i o n d e p o s i t s , o r t o t a l d e p o s i t s , b o t h o f which a r e
a v a i l a b l e . U n r e a l i z e d l o s s e s on munis a r e c a l c u l a t e d from t h e
s e c u r i t i e s a c c o u n t s ( o n l y banks w i t h a s s e t s above $ 1 b i l l i o n r e p o r t
any d e t a i l on t h e i r t r a d i n g account p o r t f o l i o s ) a s book v a l u e minus
market v a l u e a t t h e end of t h e p r e v i o u s p e r i o d .
Other u n r e a l i z e d
l o s s e s a r e c a l c u l a t e d from t h e remainder of book and market v a l u e on
t h e s e c u r i t i e s accounts.
V I . E s t i m a t i o n Procedure and R e s u l t s :
S i n c e l o a n l o s s p r o v i s i o n s i n f l u e n c e muni h o l d i n g s b u t muni
h o l d i n g s do n o t appear on t h e r i g h t - h a n d s i d e of t h e e q u a t i o n f o r
l o a n l o s s p r o v i s i o n s , we u t i l i z e a simple two-stage p r o c e d u r e .
F i r s t we e s t i m a t e t h e e q u a t i o n f o r l o a n l o s s p r o v i s i o n s , t h e n t h e
e q u a t i o n f o r munis w i t h t h e p r e d i c t e d v a l u e f o r l o a n l o s s p r o v i s i o n s
on t h e r i g h t - h a n d s i d e .
We e s t i m a t e t h e second e q u a t i o n f i r s t a s a p a n e l , c o n s i d e r i n g
t h e p o s s i b i l i t y t h a t t h e e r r o r term, u
mt'
has the following e r r o r
components s t r u c t u r e :
( 9 ) umit
- fmi
+
gmt
+
hmit'
and gmt a r e t h e bank and time e r r o r components, r e s p e c t i v e l y .
f
mi
www.clevelandfed.org/research/workpaper/index.cfm
We utilize an approach described by Fuller and Battese (1974)
to estimate the variance components, and then perform estimated
generalized least squares.' We then estimate the second equation for
each call report separately and for all reports together,
We test
for the equality of coefficients across time for both the first and
second equation. The results for the first equation lead us to
generate the predicted value for loan loss provisions from each call
report separately.
Table I presents the results for the equation for loan loss
provisions. As we would expect, higher levels of taxable income are
associated with higher loan loss provisions, since provisions reduce
book after-tax income. This is also consistent with Greenwalt and
Sinkey (1988), who found that provisions were utilized to smooth
income. Although the capital-to-assetratio (which excludes loan
loss reserves) is significant in all but one period, its sign
changes. We expected that higher levels of this variable would imply
less need to add to the loan loss reserve so as to meet primary
capital guidelines and, thus, there would be less need to provide
for loan losses. The nonaccruing and past-due loans and net
charge-offs variables are positive and significant in all periods.
Nonaccruing loans is a measure of the amount of loans that are
likely candidates for charge-offs. Net charge-offs are closely
related to the bad debt reserve tax deduction, differing from the
deduction by the amount by which allowable reserves change. The
last column of Table I presents the results from pooling all the
www.clevelandfed.org/research/workpaper/index.cfm
periods. A Chow test leads us to reject the restriction. We
generate the predicted value of loan loss provisions for the second
stage from each report separately.
Table I1 presents the results from the panel data estimation of
the second equation, both with and without a size variable.
Income,
loan loss provisions, and state and local deposits have the expected
signs and neither type of unrealized losses are significant
influences. These results are not sensitive to the inclusion of
size. However, the inclusion of size reduces the magnitude of the
coefficients on income, provisions, and deposits. If large banks
had greater availability to non-debt tax shields, we would expect
the inclusion of size to reduce the positive coefficient on income.
If large banks placed less reliance on state and local deposits,
including size would increase the positive coefficient on our proxy
for pledging requirements. As a proxy for non-debt tax shields,
size should have a negative coefficient, not a positive coefficient.
Including size also implies that relative yields have not been
significant influences on muni holdings.
Table I1 also indicates that there is no cross-sectional
lo This suggests that
component to the composite error term, u
mit '
we calculate the "between" estimator for each report separately.
These results are presented in the remaining tables.
In Tables IIIA
and IIIB, we reestimate the second equation for each report with and
without a size variable, respectively.
In general, only the coefficient on taxable income has the
expected sign (positive) in all periods, with or without inclusion
www.clevelandfed.org/research/workpaper/index.cfm
of size. When included, size is a consistently positive influence on
muni holdings. State and local deposits are a positive influence
except in the first half of 1985 and the last half of 1988. While
significant in almost all cases, the direction of influence of loan
loss provisions and relative yields varies.
However, unlike the
results detailed in Table 11, the coefficients on unrealized losses
are sometimes significant. Our specification implied that
unrealized losses might matter after TEU, when relative yields would
fall below break-even ratios.
Then, the inventory of unrealized
losses on munis would be positively related to sales (negatively
related to muni levels).
A substitute deduction, unrealized losses
on other securities, would be a positive influence. Tables IIIA and
IIIB indicate that unrealized losses on munis are generally a
positive influence after TEU but were a negative influence in 1985.
Other unrealized losses are sometimes a significant influence.
The
last column of each table indicates the results from pooling all
periods, with predicted loan loss provisions coming from pooling all
periods as well.
Again.we would reject the restriction that the
coefficient vectors are equal across reports.
In Tables IVA and IVB we present the results from estimating
the alternative model in which we have excluded the unrealized loss
variables and replaced MAX (0,ry-byr) with ry
-
byr. The results
are similar to those depicted in Tables IIIA and IIIB. Only the
coefficient on income is consistently of the expected sign. Size
consistently has a positive influence. Although we have excluded
www.clevelandfed.org/research/workpaper/index.cfm
the unrealized loss variables, which might be affected by movements
in market yields, the coefficient on rel-ative yields is often
negative and significant.
The last columns of Tables IVA and IVB are the estimates made
when all reports are stacked together.
Again, the restrictions that
the coefficients be equal across periods are rejected. However, if
we compare the last columns of Tables IIIA and IVA and the last
columns of Tables IIIB and IVB, the implications of the two
alternative models for the influences of income, yields, deposits,
and size seem similar.
VII.Conclusion and Possible Extensions
This paper has attempted to extend the analysis of bank demand
for municipal securities to consider the influence of state pledging
requirements, factors that could determine the sell-off of munis
when relative yields do not generally justify new purchases, and
simultaneity with loan loss provisions.
Implicit in our analysis
was a hypothesis that relative yields and income as determinants of
muni demand declined in importance with the passage of the Tax
Reform Act of 1986 and that factors influencing loss realization and
loan-loss provision increased in importance.
We feel that the results regarding the significance of state
pledging requirements warrant further investigation, especially in
light of recent controversies about the differential impact of TRA
on state and local finance. In addition, provisions for loan losses
and unrealized securities losses are sometimes significant
determinants of muni holdings. However, the influence of relative
www.clevelandfed.org/research/workpaper/index.cfm
yields, which were sometimes negatively related to muni holdings, is
hard to reconcile with our model or with other models of muni
demand.
In further work, the influence of state pledging requirements
or other state regulations could be explored, given the detail
provided by the Advisory Council on Intergovernmental Relations
(1989) or the Conference of State Bank Supervisors. The analysis of
the influence of loss-realization timing could be explored,
utilizing information on the trading accounts of large banks.
However, this avenue is limited by the paucity of data on the
maturities of bank securities. Finally, the econometric procedure
could be designed to more explicitly take advantage of the
simultaneity between loan loss provisions and muni holdings in a
panel framework.
www.clevelandfed.org/research/workpaper/index.cfm
Table I
First Stage Estimates:
Dependent Variable: Loan Loss Provisions /Total Assets
t-1
t
Variable
Constant
Capital-to-Asset
Ratio
t-1
0.0001
0.005
-0.002
0.013
(.001)
(.OOl)**
(.OOl)*
(.OOl)**
Nonaccruing and PastDue Loans
t-1
0.050
0.081
0.055
0.106
(.002)** (.003)** (.002)** (.003)**
Net C h a r g e - O f f ~ ~ - ~
0.700
0.6.15
0.276
0.505
(.014)** (.012)** (.008)** (.013)**
Loan-Loss Reserve
-
SSE
2
R (adjusted)
t-1
.lo1
-0.09
0.070
-0.036
(.Oil)** (.014)** (.012)** (.015)**
www.clevelandfed.org/research/workpaper/index.cfm
Table I (continued)
First Stage Estimates:
Dependent Variable: Loan Loss Provisions /Total Assets
t
t-1
Variable
Constant
0.0004
0.0004
0.0004
-0.0011 0.0001
(.0001)**(.0002)**(.0001)**(.0002)**(.0001)*
Capital-Asset
Ratio
t-1
-0.002
(.001)
0.003
(.OOl)**
- .0004 0.006
0.002
(.0009) (.002)**(.0004)**
Nonaccruing and
0.061
0.098
0.058
0.099
(.002)** (.003)** (.002)** (.004)**
Past Due Loans
t-1
Charge Offs
-
0.086
(.OOl)**
0.128
0.598
0.309
0.670
0.371
(.007)** (.013)** (.008)** (.015)** (.004)**
Loss Reserve
t-1
0.057
-0.137 -.048
-0.032
(.010)** (.010)** (.007)** (.012)**
-0.030
(.004)**
SSE
0.293
0.423
0.205
0.638
3.628
2
R (adjusted)
0.187
0.385
0.284
0.361
0.286
Number of observations: 12,035.
* :significant at .lo.
** : significant 'at .05.
Note: All variables are scaled by lagged total assets.
Source: Author's calculations.
www.clevelandfed.org/research/workpaper/index.cfm
Table I1
Time Series/Cross-Sectional Estimates of the Equation for
Municipal Securities
Dependent Variable: (BVM t -BVMt-l)/Total Assets t-1
With Size
Without Size
Variable
Constant
Unrealized
Muni Losses
t-1
Loan Loss
Provisions
t
(from 1st stage)
State and Local
Deposits
t
0.1766
( .0065)**
Other Unrealized
Losses
t
0.0131
( .0105)
ln(Tota1 Assets )
t
0.0573
( .0008)**
Error Components
Cross-Sectional
Time Series
Error
0.000000
0.000025
0.000652
0.000000
0.000026
0.000691
MSE of Transformed
Regression
0.000638
0.000674
Degrees of Freedom
96,272
*
96,273
:significant at .lo.
**:significant at .05.
All variables other than (1-L)MAX( 0, ry-byr )t, and
(1-L)ln (Total Assets) are divided by lagged Total Assets.
Source: Author's calculations.
www.clevelandfed.org/research/workpaper/index.cfm
Table IIIA
Second Stage Estimates of the Equation for
Municipal Securities
Dependent Variable: (BVMt-BVMt-l)/Total Assets t-1
(Without Size as an Independent Variable)
Variable
Constant
Unrealized
Muni Losses
-0.355
(.036)**
-0.614
(.067)**
-0.318
(.078)**
-0.012
(.036)
-0.901
(.072)**
-1.37
(.067)**
2.078
(.122)**
-0.182
(.039)%*
0.00007 0.120
0.556
0.056
(.018)
(.019)**
(.022)**
(.014)**
-0.021
-0.447
-0.029
(.028)
(.038)
(.040)**
(.018)
SSE
7.35
11.93
18.44
4.51
2
R (adjusted)
0.027
0.048
0.315
0.051
t-1
Loan Loss
Provisionst
(from 1st stage)
State and Local
Deposits
t
Other Unrealized
Losses
t
- 0.024
www.clevelandfed.org/research/workpaper/index.cfm
Table I I I A ( c o n t i n u e d )
Second S t a g e E s t i m a t e s o f t h e E q u a t i o n f o r
Municipal S e c u r i t i e s
Dependent V a r i a b l e : (BVM -BVMt-l)/Total A s s e t s
t
t-1
(Without S i z e a s a n Independent V a r i a b l e )
Variable
Constant
-0.007
-0.0003
-0.003
-0.002
-0.0015
(.0006)**(.0002)**(.0002)**(.0001)**(.0001)**
Unrealized
Muni Losses
Loan Loss
Provisions
t-1
t
S t a t e and Local
Deposits
t
0.021
(.035)
0.346
0.251
0.414
-0.050
(.034)** (.050)** (.035)** (.017)**
2.039**
(.094)
-0.058
(.036)
0.626
-0.078
0.237
(.070)** (.023)** (.025)**
0.290
0.067
0.247
-0.005
( 0 2 ) ( 0 4 ) (.07)** ( 0 0 )
0.242
(.007)**
Other U n r e a l i z e d 0 . 2 0 3
-0.006
Losses
(.023)** ( . 0 2 3 )
0.114
0.080
-0.0002
(.033)** (.021)** ( . 0 1 1 )
SSE
6.38
3.06
4.23
1.76
67.07
2
R (adjusted)
0.618
0.058
0.097
0.030
0.168
t
Number o f o b s e r v a t i o n s : 1 2 , 0 3 5 .
* :significant a t .lo.
**:significant a t .05.
Note: A l l v a r i a b l e s o t h e r t h a n (1-L)MAX( 0 , r y - b y r ) t a r e
d i v i d e d by l a g g e d T o t a l A s s e t s .
Source: A u t h o r ' s c a l c u l a t i o n s .
www.clevelandfed.org/research/workpaper/index.cfm
Table IIIB
Second Stage Estimates of the Equation for
Municipal Securities
Dependent Variable: (BVM -BVMt-l)/Total Assets
t
t-1
(With Size as an Independent Variable)
Variable
Constant
Unrealized
Muni Losses
t-1
-0.291
(.035)**
Loan Loss
Provisions
t
(from 1st stage)
-0.680 -1.190
2.489
-0.102
(.070)** . 0 6 7 * * 4 ) * * (.039)**
State and Local
Deposits
-0.042
0.043
0.397
0.022
(.018)** (.019)** (.021)** (.014)
Other Unrealized
Losses
-0.020
(.027)
t
t
ln(Tota1 Assets )
t
SSE
R 2 (adjusted)
.
-0.558 0.134
(.059)** (.072)*
0.029
(.038)
-0.007
(.036)
-0.359 -0.024
(.037)** (.018)
0.049
0.053
0.155
(.002)** (.003)** (.004)**
0.036
(.002)**
www.clevelandfed.org/research/workpaper/index.cfm
Table IIIB (continued)
Second Stage Estimates of the Equation for
Municipal Securities
Dependent Variable: (BVM -BVMt-l)/Total Assets
t
t- 1
(With Size as an Independent Variable)
Variable
Constant
-0.008
-0.004
-0.004
-0.003 -0.004
(.0005)**(.0002)**(.0002)**(.0001)**(.0001)**
Unrealized
Muni Losses
t-1
0.062
0.366
0.277
0.418
- .023
(.034)*
(.033)**
(.047)**
(.034)**
(.016)
Loan Loss
Provisions
t
2.177
0.137
0.608 -0.024
(.090)** (.035)** (.002)** (.023)
0.409
(.024)**
(1-L)*. .
MAX(0,ry-byr)
-0.006
(.006)
0.087
-0.021
(.017)**(.025)
-0.059
(.038)
0.028
(.OOl)**
State and Local
Deposits
t
0.205
0.027
0.158
-0.023
0,170
(.020)**
(.014)*
(.016)**
(.010)**
(.007)**
Other Unrealized 0.211
Losses
t
(.022)**
-0.006
0.056
0.054
0.018
(.022)
(.032)*
(.020)**
(.010)*
SSE
5.90
2.88
3.75
1.69
63.12
R 2 (adjusted)
0.647
0.112
0.199
0.072
0.217
Number of observations: 12,035.
* :significant at .lo.
**:significant at .05.
Note: All variables other than (1-L)MAX{ 0, ry-byr ) , and
(1 -L)lnTotal Assets are divided by lagged Total ~sseEs.
Source: Author's calculations.
www.clevelandfed.org/research/workpaper/index.cfm
Table IVA
Second Stage Estimates of the Equation for
Municipal Securities
Dependent Variable: (BVM -BVMt-l)/Total Assets
t
t-1
(Without Size as an Independent Variable)
(Without Unrealized Capital Losses as Independent Variables)
6/85
Variable
Constant
Loan Loss
Provisions
t
(from 1st stage)
State and Local
Deposits
t
SSE
2
R (adjusted)
12/85
6/86
12/86
www.clevelandfed.org/research/workpaper/index.cfm
Table I V A (continued)
Second Stage Estimates of the Equation for
Municipal Securities
Dependent Variable: (BVMt-BVMt-l)/T~talAssets
t-1
(Without Size as an Independent Variable)
(Without Unrealized Capital Losses as Independent Variables)
Variable
Constant
Loan Loss
Provisions
t
(1-L)*.
.
State and Local
Deposits
t
0.293
0.066
.
0
SSE
6.43
3.09
R 2 (adjusted)
0.615
0.050
4
0.250
* (.07)**
-0.006
0.241
(00)
(.025)**
4.25
1.79
67.09
0.094
0.017
0.168
Number of observations: 12,035.
* :significant at .lo.
**:significant at .05.
Note: All variables other than (1-L)(ry-byr) t are divided by
lagged Total Assets.
Source: Author's calculations.
www.clevelandfed.org/research/workpaper/index.cfm
Table IVB
Second Stage Estimates of the Equation for
Municipal Securities
Dependent Variable: (BVM -BVMt-l)/Total Assets
t
t-1
(With Size as an Independent Variable)
(Without Unrealized Capital Losses as Independent Variables)
Variable
Constant
Loan Loss
Provisions
t
(from 1st stage)
State and Local
Deposits
t
ln(Tota1 Assets )
t
SSE
2
R (adjusted)
www.clevelandfed.org/research/workpaper/index.cfm
Table IVB (continued)
Second Stage Estimates of the Equation for
Municipal Securities
Dependent Variable: (BVMt-BVMt-l)/TotalAssets
t-1
(With Size as an Independent Variable)
(Without Unrealized Capital Losses as Independent Variables)
Variable
Constant
-0.011 -0.006 -0.005 -0.004 -0.004
(.0094)~~*(.0002)**(.0002)**(.0001)**(.0001)**
Loan Loss
Provisions
2.227
(.088)** (.035)** (.066)** (.022)
(.024)**
State and Local
Deposits
0.214
0.029
0.162 -0.024
(.020)** (.014)** (.016)** (.OlO)**
0.170
(.007)**
SSE
5.94
2.92
3.76
1.70
63.23
0.644
0.102
0.197
0.065
t
t
2
R (adjusted)
0.196
0.649
-0.004
0.408
0.215
Number of observations: 12,035.
* :significant at .lo.
**:significant at -05.
Note: All variables other than (1-L)(ry-byr)t' and (1-L)lnTotal
Assets are divided by lagged Total Assets.
Source: Author's calculations.
www.clevelandfed.org/research/workpaper/index.cfm
Footnotes
1) Property and casualty insurance companies essentially
deducted all of their interest expense via the reserve
deduction until 1986. Non-financial corporations can deduct
all interest expense as long as tax-exempts constitute no more
than 2 percent of total assets.
2) See A Profile of State Chartered Banking, Council of State
Bank Supervisors, 1988.
3) See Significant Facts About Fiscal Federalism, Advisory
Council on Intergovernmental Relations, Washington, D.C., 1977.
4) The essential difference between the two categories is that,
for municipals, the amortization of the basis that occurs when
the purchase price exceeds par is not a deduction from income.
When municipals are at a deep discount and are being compared
to equivalent taxables, the right to amortize the basis is of
little value.
5)
A
complication that arises at this point is that income
smoothing may be more appropriately applied to analysis of book
income while muni holdings are more directly related to tax
return income. We deal with this when we discuss our income
measure, which is constructed with the call report (book) data.
www.clevelandfed.org/research/workpaper/index.cfm
6) Neubig and Sullivan (1987) provide a detailed description of
calculation of the byr relevant to a bank facing the amt.
7) As we discuss in our calculation of taxable income, the
equivalent deduction for tax purposes is the maxim&
allowable
addition to the bad-debt reserve.
8) The first formulation implies other restrictions as well
One is that variation in relative yields only influences
purchases if ry - byr is positive, ex-post.
9) The actual calculations are done by the SAS routine TSCSREG.
10) Actually, the estimated cross-sectional variance component
is negative, then set to zero in the estimated GLS procedure
(EGLS).
Baltagi (1981) indicates that it is difficult in
practice to distinguish between misspecification and actually
having a zero variance component. Baltagi also indicates that
setting such components to zero in the EGLS procedure does not
damage the performance of the estimation procedure
www.clevelandfed.org/research/workpaper/index.cfm
References
Advisory Committee on Intergovernmental Relations. The Impact
of Increased Insurance on Public Deposits. Washington, D.C.:
U.S. Government Printing Office (1977).
. Sianificant Facts About Fiscal Federalism.
Washington, D.C.: U.S. Government Printing Office (1989).
Baltagi, Badi H. "Pooling: An Experimental Study of Alternative
Testing and Estimation Procedures in a Two-Way Error Component
Model." Journal of Econometrics 17 (September 1981). 21-49.
Conference of State Bank Supervisors. A Profile ofstate
Chartered Banking. Washington, D.C.: 1988.
Constantinides, George M . , and Ingersoll, Jonathan E. "Optimal
Bond Trading with Personal Taxes." Journal of Financial
Economics 13 (September 1984). 299-335.
Fortune, Peter. "Municipal Bond Yields: Whose Tax Rates
Matter?" National Tax Journal 41 (June 1988). 219-233.
Forbes, Ronald W., and Leonard, Paul A. "The Effects of
Statutory Portfolio Constraints on Tax-Exempt Interest Rates."
Journal of Monev. Credit. and Banking 16 (February 1984).
93-99.
Fuller, Wayne A , , and Battese, George E. "Estimation of Linear
Models with Crossed-Error Structure." Journal of Econometrics
2 (May 1974). 67-78.
Greenwalt, Mary B . , and Sinkey, Joseph F. "Bank Loan-Loss
Provisions and the Income-Smoothing Hypothesis: An Empirical
Analysis, 1976-1984." Journal of Financial Services Research 1
(December 1988). 301-318.
Heaton, Hal. "The Relative Yields on Taxable and Tax-Exempt
Debt." Journal of Money. Credit, and Banking 18 (November
1986). 482-494.
Hendershott, Patric H . , and Koch, Timothy W. "The Demand for
Tax-Exempt Securities by Financial Institutions." Journal of
Finance 35 (June 1980). 717-727.
Kidwell, David S . , Koch, Timothy W . , and Stock, Duane R.
"Issue Size and Term-Structure Segmentation Effects on Regional
Yield Differentials in the Municipal Bond Market." Journal of
Economics and Business 39 (November 1987). 339-347.
www.clevelandfed.org/research/workpaper/index.cfm
Kimball, Ralph C. "Commercial Banks, Tax Avoidance, and the
Market for State and Local Debt since 1970." New Ennland
Economic Review January/February 1977. 3-21.
Miller, Merton H. "Debt and Taxes." Journal of Finance. 32 (May
1977). 261-275.
Neubig, Thomas S . , and Sullivan, Martin A. (1987a). "The Impact
of the Tax Reform Act of 1986 on Commercial Banks." Com~endium
of Tax Research 1987. Office of Tax Analysis, Department of
the Treasury, Washington, D.C. 279-305.
(1987b). "The Implications of Tax Reform for Bank
Holdings of Tax-Exempt Securities." National Tax Journal 40
(September 1987). 403-418.
O'Brien, James M., and Gelfand, Matthew D. "Effects of the Tax
Reform Act of 1986 on Commercial Banks." Tax Notes 34 (February
9 , 1987). 597-604.
Poterba, James M. "Tax Reform and the Market for Tax-Exempt
Debt." National Bureau of Economic Research Working Paper No.
2900 (March 1989).
Skelton, Jeffrey L. "Banks, Firms, and the Relative Pricing of
Tax-Exempt and Taxable Bonds." Journal of Financial Economics
12 (November 1983). 343-355.
www.clevelandfed.org/research/workpaper/index.cfm
@FedFRASER