FRBSF Economic Letter
2006-10; May 12, 2006
Bank Diversification, Economic Diversification?
Business cycle volatility has fallen in the United States during
the past two decades. Trehan (2005) explains some of the possible
mechanisms behind our now more stable economy. Some researchers
have argued, for instance, that businesses manage inventory better
today than in the past, or that innovations in financial markets
have helped smooth out business fluctuations; others have emphasized
better economic policy; still a third camp argues for nothing
more than good luck.
This Economic Letter explores in some detail one aspect of
better finance. Changes in regulations during the 1980s and early
facilitated a more integrated banking system, which in turn
helped states share risks better.
Changes in U.S. banking
In the 1970s, the United States had a balkanized banking sector.
Most states restricted banks' ability to open branches,
and all states prevented out-of-state bank holding companies
their banks. The U.S. had almost 15,000 banks, most of
them very small and very local. There were something like 50
systems, one per state, rather than a single integrated
The shape and structure of U.S. banking has changed drastically
since deregulation in the 1970s. Banks may now branch
more freely (both within and across state lines) and bank holding
may buy banks anywhere. These changes started with state-level
branching reforms in the 1970s, accelerated during the
1980s as states began to allow out-of-state bank holding
to buy their banks, and were completed in the middle
the 1990s with federal legislation allowing banks to
operate nationwide. While some regulatory constraints remain
example, no bank
may hold more than 10% of deposits nationally), by and
the U.S. has moved toward a more open banking system.
As a result of these regulatory changes, banks are now
larger and better diversified. For example, the share
held by banks with over $10 billion in assets (year-2000
rose from 36% in 1980 to 70% by 2000. Banks are not
only bigger today than in the past, but banks and banking
also geographically broader. In the middle of the 1970s
only 10% of
the typical state's banking-system assets were owned
by organizations with operations outside the state.
about 65% by the middle of the 1990s as reform allowed
companies to buy banks across the country. Thus, the
U.S. now has a single, well-integrated banking system
operating across many states.
The changes in bank regulations have altered not only
the size and geographical scope of banks but also their
By opening new avenues for bank takeovers and for bank
expansion into new markets, deregulation has increased
on bank managers, leading to greater efficiency, higher
quality, and lower pricing of bank services (Jayaratne
Dick, 2006). Bank efficiency itself increased through
a powerful competitive shakeout that occurred with
better run banks gained market share over higher-cost
What are the expected consequences of banking integration?
Bigger and broader banks are almost surely better diversified,
but are they in fact safer? Early evidence from
the 1930s and before suggests that large and geographically
weather economic downturns better than smaller
banks. For example, the U.S. experienced periodic banking
century and into the early part of the 20th century.
During the Great Depression years—1930 through
and 12.9% of U.S. banks failed in each year; by
the end of that four-year stretch, almost half of U.S.
or merged. Bernanke (1983) argues that this banking
crisis worsened the magnitude of the downturn because
supply fell as banks
failed. Thus, many firms were unable to finance
potential investments. Most of the failed banks were small
and operated out of just
a single office. In Canada, where not a single
bank failed, branching was the rule; in fact, Canada had
large banks during
the 1930s. The Canadian economy fared much better
than did the United States economy, in large part because
of its better
and integrated banking system.
History thus suggests that bigger and better diversified
banks are safer. Of course, history need not repeat
studies of modern consolidation suggest that banks
increase their leverage
following mergers or acquisitions, which tends
to offset the risk-reducing effects of diversification.
(1997) find that large banks today, while clearly
better diversified, are not safer than small banks
they tend to hold riskier
loans and finance themselves with less equity (leading
to higher leverage). So, active management of banks
offset the potential stabilizing effects of size
Even with no change in bank risk, geographical diversification
and consolidation integrates our banking system,
which has potential spillover effects on local
volatility measured at the state level). Integration
allows banking resources to flow between states.
example, was traditionally a local business dominated
by local lenders. Before deregulation, the fortunes
the local business community were inextricably
linked. Today, however, banks are less exposed to the local
tend to lend to small businesses over much greater
they tend to operate branches widely across broad
regions (Petersen and Rajan, 2002). In turn, the
is less exposed
to the fortunes of local banks, partly because
firms are less likely to borrow locally and partly because
by multi-state holding companies can readily access
capital through affiliated banks operating elsewhere.
longer imply declines in bank capital and credit
availability. Integration reduces both the effect
of local business
downturns on banks and the sensitivity of local
business to banking
The story does not end quite there. Integrated banks,
while better diversified against local economic
shocks, are also
to drain financial resources in response to downturns.
Remember, before deregulation, banks and businesses
other's problems. Therefore, if the local business
lost money, so did
the local bank. With limited opportunities to invest,
however, local banks tended to stick with their
good times and bad. Integrated banks—banks with
operations in many
markets—may choose to respond to local downturns
by lending elsewhere. This kind of capital reallocation,
by integration, could actually worsen the impact
How did local volatility change after U.S. banking
Given these theoretical uncertainties, it seems natural
simply to test empirically whether or not local economic
has increased or decreased with banking integration.
Morgan, Rime, and Strahan (2004) test how the magnitude
economic shocks changed after states permitted interstate
banking deregulation. They show first that the ownership
of a state's
banks by out-of-state banking organizations rose
sharply after interstate reform, thereby integrating
with the rest
of the country. They next isolate the local business
cycle for each state in each year from the middle
of the 1970s
deregulation) to the middle of the 1990s (the end
of deregulation). Then, they compute the change in
volatility after interstate banking reform relative
to the change in volatility
over the same years in states that were still regulated.
By comparing the change in volatility to non-deregulating
of trends unrelated to banking reform can be removed.
Though a bit crude (because the "control group" composition
changes as more states deregulate), this calculation
reveals whether most states experienced more or less
deregulation. In fact, all but four states experienced
lower employment growth fluctuations after deregulation.
The magnitude of the decline in volatility has been
quite large. The typical state in the typical year
deviation in the growth of employment of about
2 percentage points from average growth. In other words,
it is not
unusual for a
state to grow 2% faster or 2% slower than average.
The size of this typical deviation, however, fell
percentage point after interstate banking reform,
meaning that deviations around average growth are
Why does local economic volatility fall after banking
deregulation? It seems that the answer must have
to do with integration
that allows the banking system to become more robust
to local shocks
via diversification. To test whether this expected
channel actually explains the data, Strahan (2003)
the annual growth rate in a state's economy and
the annual growth rate of capital in that state's banks,
both the national business cycle as well as differences
in long-run growth prospects across states. This
correlation was very high
during the years of banking disintegration, prior
to the expansion of bank branching and cross-state
the estimates suggest that a 10% decline in bank
capital was associated with a decline in state-level
This correlation, however, declined to nearly zero
after states permitted interstate banking. In other
the health of
the banking system (measured by the growth in capital)
little with the health of the local economy. Since
banks no longer become distressed during local
thus allowing business to recover more quickly.
As other researchers have noted, the U.S. economy
has become much more stable over the past 20 years.
have also been dramatic during this same period,
with deregulation and consolidation leading to
dominated by large, multistate banking organizations.
spearheaded by individual states made it easier
for banks to protect their capital and profits from local
better diversified. The net effect of bank diversification
been both lower levels of volatility at the state
level and a reduction in the link between the local
local banking system. Given that state economies
became less volatile
after these interstate banking reforms, the evidence
banking integration as one—though probably not
the only—piece of the puzzle to explain why the U.S.
economy has become
Philip E. Strahan
Visiting Scholar, FRBSF, and
Boston College, Wharton Financial Institutions Center & NBER
accessed May 2006.]
Bernanke, Ben. 1983. "Nonmonetary Effects
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Demsetz, Rebecca S., and Philip E. Strahan.
Size, and Risk at U.S. Bank Holding Companies." Journal
of Money, Credit, and Banking 29, pp. 300-313.
Dick, Astrid. 2006. "Nationwide Branching
and Its Impact on Market Structure, Quality,
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Jayaratne, Jith, and Philip E. Strahan. 1998. "Entry
Restrictions, Industry Evolution, and Dynamic
Efficiency: Evidence from Commercial Banking." Journal
of Law and Economics 41(1), pp. 239-274.
Morgan, Donald P., Bertrand Rime, and Philip
E. Strahan. 2004. "Bank Integration and
State Business Cycles." Quarterly Journal
of Economics 119(4), pp. 1555-1585.
Petersen, Mitchell, and Raghuram G. Rajan.
Distance Still Matter? The Information Revolution
in Small Business Lending." Journal
of Finance 57(6).
Strahan, Philip E. 2003. "The Real Effects
of U.S. Banking Deregulation." FRB St. Louis
Trehan, Bharat. 2005. "Why
Has Output Become Less Volatile?" FRBSF Economic Letter 2005-24
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