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
1990s
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
from buying
their banks. The U.S. had almost 15,000 banks, most of
them very small and very local. There were something like 50
little
banking
systems, one per state, rather than a single integrated
system.
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
companies
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
companies
to buy their banks, and were completed in the middle
of
the 1990s with federal legislation allowing banks to
operate nationwide. While some regulatory constraints remain
(for
example, no bank
may hold more than 10% of deposits nationally), by and
large
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
of assets
held by banks with over $10 billion in assets (year-2000
dollars)
rose from 36% in 1980 to 70% by 2000. Banks are not
only bigger today than in the past, but banks and banking
companies are
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.
This fraction
rose to
about 65% by the middle of the 1990s as reform allowed
bank holding
companies to buy banks across the country. Thus, the
U.S. now has a single, well-integrated banking system
with institutions
operating across many states.
The changes in bank regulations have altered not only
the size and geographical scope of banks but also their
efficiency.
By opening new avenues for bank takeovers and for bank
expansion into new markets, deregulation has increased
competitive
pressure
on bank managers, leading to greater efficiency, higher
quality, and lower pricing of bank services (Jayaratne
and Strahan,
1998;
Dick, 2006). Bank efficiency itself increased through
a powerful competitive shakeout that occurred with
consolidation, as
better run banks gained market share over higher-cost
and
lower-profit
competitors.
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
diversified
banks
weather economic downturns better than smaller
banks. For example, the U.S. experienced periodic banking
panics during
the 19th
century and into the early part of the 20th century.
During the Great Depression years—1930 through
1933—5.6%, 10.5%,
7.8%,
and 12.9% of U.S. banks failed in each year; by
the end of that four-year stretch, almost half of U.S.
banks
had either
closed
or merged. Bernanke (1983) argues that this banking
crisis worsened the magnitude of the downturn because
credit
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
only ten
large banks during
the 1930s. The Canadian economy fared much better
than did the United States economy, in large part because
of its better
diversified
and integrated banking system.
History thus suggests that bigger and better diversified
banks are safer. Of course, history need not repeat
itself. Some
studies of modern consolidation suggest that banks
increase their leverage
following mergers or acquisitions, which tends
to offset the risk-reducing effects of diversification.
Demsetz
and Strahan
(1997) find that large banks today, while clearly
better diversified, are not safer than small banks
because
they tend to hold riskier
loans and finance themselves with less equity (leading
to higher leverage). So, active management of banks
can and
often does
offset the potential stabilizing effects of size
and diversification.
Even with no change in bank risk, geographical diversification
and consolidation integrates our banking system,
which has potential spillover effects on local
business-cycle volatility
(for example,
volatility measured at the state level). Integration
allows banking resources to flow between states.
Small
business
lending, for
example, was traditionally a local business dominated
by local lenders. Before deregulation, the fortunes
of the
banker and
the local business community were inextricably
linked. Today, however, banks are less exposed to the local
economy: they
tend to lend to small businesses over much greater
distances, and
they tend to operate branches widely across broad
regions (Petersen and Rajan, 2002). In turn, the
local economy
is less exposed
to the fortunes of local banks, partly because
firms are less likely to borrow locally and partly because
local
banks owned
by multi-state holding companies can readily access
capital through affiliated banks operating elsewhere.
Thus, local
downturns no
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
downturns.
The story does not end quite there. Integrated banks,
while better diversified against local economic
shocks, are also
better able
to drain financial resources in response to downturns.
Remember, before deregulation, banks and businesses
inherited each
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
customers through
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,
made easier
by integration, could actually worsen the impact
of
local shocks.
How did local volatility change after U.S. banking
integrated?
Given these theoretical uncertainties, it seems natural
simply to test empirically whether or not local economic
volatility
has increased or decreased with banking integration.
Morgan, Rime, and Strahan (2004) test how the magnitude
of state-specific
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
the state
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
(just before
deregulation) to the middle of the 1990s (the end
of deregulation). Then, they compute the change in
average
employment growth
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
states,
the effects
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
volatility after
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
experienced
an absolute
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
by about
one-half
of a
percentage point after interstate banking reform,
meaning that deviations around average growth are
about 25%
smaller than
before.
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)
reports the
relationship between
the annual growth rate in a state's economy and
the annual growth rate of capital in that state's banks,
after controlling
for
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
bank
ownership.
For instance,
the estimates suggest that a 10% decline in bank
capital was associated with a decline in state-level
growth
of about
1.3%.
This correlation, however, declined to nearly zero
after states permitted interstate banking. In other
words,
the health of
the banking system (measured by the growth in capital)
now varies
little with the health of the local economy. Since
banks no longer become distressed during local
downturns, credit
remains
available,
thus allowing business to recover more quickly.
Conclusions
As other researchers have noted, the U.S. economy
has become much more stable over the past 20 years.
Changes
in banking
have also been dramatic during this same period,
with deregulation and consolidation leading to
a better
integrated system
dominated by large, multistate banking organizations.
Regulatory change
spearheaded by individual states made it easier
for banks to protect their capital and profits from local
downturns
by becoming
better diversified. The net effect of bank diversification
has
been both lower levels of volatility at the state
level and a reduction in the link between the local
economy
and the
local banking system. Given that state economies
became less volatile
after these interstate banking reforms, the evidence
points to
banking integration as one—though probably not
the only—piece of the puzzle to explain why the U.S.
economy has become
less volatile. Philip E. Strahan
Visiting Scholar, FRBSF, and
Boston College, Wharton Financial Institutions Center & NBER
References
[URLs
accessed May 2006.]
Bernanke, Ben. 1983. "Nonmonetary Effects
of the Financial Crisis in the Propagation of
the Great Depression." American Economic
Review 73(3), pp. 257-276.
Demsetz, Rebecca S., and Philip E. Strahan.
1997. "Diversification,
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,
and Bank Performance." Journal of Business 79(2).
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.
2002. "Does
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
Review 85(4).
Trehan, Bharat. 2005. "Why
Has Output Become Less Volatile?" FRBSF Economic Letter 2005-24
(September 16).
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do not necessarily reflect the views of the management
of the Federal Reserve Bank of San Francisco or of the
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