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Federal Reserve Bank of St. Louis working papers are preliminary materials circulated to stimulate discussion and critial comment.

Banking

Year-End Seasonality in One-Month LIBOR Derivatives,

We examine the markets for one-month LIBOR futures contracts and options on those futures for a year-end price effect consistent with the previously identified year-end rate increase in one-month LIBOR. The cash market rate increase appears in forward rates and derivative prices, which allows the derivatives to properly hedge year-end interest rate risk. However, while the year-end effect appears in the derivative contract, these derivative contracts provide biased forecasts of both future interest rates and their volatility. The bias appears to be different at year's end for the LIBOR futures contract, but not for the options contract. The information in the derivatives almost always subsumes simple benchmark forecasts.

Input Inefficiency In Commercial Banks: A Normalized Quadratic Input Distance Approach

A normalized quadratic input distance function is proposed with which to estimate technical efficiency on commercial banks regulated by the Federal Reserve System. The study period covers 1990 to 2000 using individual bank information from the Call and Banking Holding Company Database. A stochastic frontier model is specified to estimate the input normalized distance function and obtain measures of technical efficiency.

The Federal Reserve Responds to Crises: September 11th Was Not the First

A primary purpose of the Federal Reserve Act of 1913 was to prevent banking panics by establishing the Federal Reserve System to function as a lender of last resort. Other types of financial crisis require similar response, however, and the Federal Reserve has repeatedly used its capacity to generate liquidity to insulate the economy from crises in financial markets. The Fed's response to the terrorist attacks of September 11, 2001 is the most recent example of this. This paper reviews the Fed's responses to crises and potential crises in financial markets. The cases of the stock market crash of 1987, the Russian default and the September 11th attack are studied.

Entrepreneurship and the Deregulation of Banking

This paper presents evidence that banking deregulation led to decreases in entrepreneurship in some U.S. regions, and to increases in others. This is contrary to recent research that found an unambiguous positive relationship.

New Evidence on the Fed's Productivity in Providing Payments Services

As the dominant provider of payments services, the efficiency with which the Federal Reserve provides such services in an important public policy issue. This paper examines the productivity of Federal Reserve check-processing offices during 1980-1999 using non-parametric estimation methods and newly developed methods for non-parametric inference and hypothesis testing. The results support prior studies that found little initial improvement in the Fed's efficiency with the imposition of pricing for Federal Reserve services in 1982. However, we find that median productivity improved substantially during the 1990s, and the dispersion across Fed offices declined.

Intermediaries and Payments Instruments

We Study an economy in which intermediaries have incentives to issue circulating liabilities as part of an equilibrium. We show that, with arbitrarily small transactions costs, only the liabilities of intermediaries will circulate, and not those of other private sector agents. Therefore, our model connects intermediation activity with the issuance of payments media, a connection that has not been made in earlier literature. We also describe conditions under which equilibrium outcomes may be volatile when private liabilities circulate. Finally, we use our model to suggest a resolution of the "banknote underissue puzzle" of Cagan (1993).

The Importance of Scale Economies and Geographic Diversification in Community Bank Mergers

Mergers of community banks across economic market areas potentially reduce both idiosyncratic and local market risk. A merger may reduce idiosyncratic risk because the larger post-merger bank has a larger customer base. Negative credit and liquidity shocks from individual customers would have smaller effects on the portfolio of the merged entity than on the individual community banks involved in the merger. Geographic dispersion of banking activities across economic market areas may reduce local market risk because an adverse economic development that is unique to one market area will not affect a bank?s loans to customers located in another market area. This paper simulates the mergers of community banks both within and across economic market areas by combining their call report data. We find that idiosyncratic risk reduction dominates local market risk reduction. In other words, a typical community bank can diversify away its idiosyncratic risk almost as completely by merging with a bank across the street as it can by merging with one located across the country. The bulk of the pure portfolio diversification effects for community banks, therefore, appear to be unrelated to diversification across market areas but, instead, are related to bank size. These findings help explain why many community banks have not pursued geographic diversification more aggressively, but they beg the question as to why more small community banks do not pursue in-market mergers.

Consolidation in US Banking: Which Banks Engage in Mergers?

The number of U.S. commercial banks has declined by some 40 percent since 1984, primarily through mergers of solvent institutions. The relaxation of legal impediments to branching has enabled this consolidation, but specific characteristics of banks that engage in mergers reflect the regulatory process and market structure, as well as the bank's own condition. This paper seeks to quantify the regulatory, market, and financial characteristics that affect the probability of a bank engaging in mergers and the volume of banks it absorbs over time. We examine separately consolidation within holding companies and mergers of independent banks.

Do Depositors Care About Enforcement Actions?

Since 1990, federal bank supervisors have publicly announced formal enforcement actions. This change in regime provides a natural laboratory to test two propositions: (1) claims by economists that putting confidential supervisory information in the public domain will enhance market discipline and (2) claims by bank supervisors that releasing such data will spark runs. To evaluate these propositions, we measure depositor reaction to 87 Federal Reserve announcements of enforcement actions. We compare deposit growth rates and yield spreads before and after the announcements at the sample banks and a control group of peer banks. The data show no evidence of unusual deposit withdrawals or spread increases at the sample banks following the announcements of formal actions. These results suggest that public announcements of enforcement actions did not spark bank runs or enhance depositor discipline. Apparently, depositors did not care a great deal about our sample actions.

Banks VS. Credit Unions: Dynamic Competition in Local Markets

One interesting aspect of the financial services industry is that for-profit institutions such as commercial banks compete directly with not-for-profit financial intermediaries such as credit unions. In this article, we analyze competition among banks and between banks and credit unions using a dynamic model of spatial competition. The model allows for the co-existence of (for-profit) banks and (not-for-profit) credit unions. Using annual county-level data on banking market concentration and credit-union participation rates for the period 1989-96, we find empirical evidence of two-way competitive interactions between banks and credit unions.

The Contribution of On-Site Examination Ratings to an Empirical Model of Bank Failures

This paper investigates how well regulator examinations predict bank failures, and how best to incorporate examination information into an econometric model of time-to-failure. We estimate proportional hazard models with time-varying covariates and find that examiner ratings help explain the failure hazard. Both the overall rating of a bank's condition and management, i.e., the composite CAMELS rating, and ratings of specific components contain information. In addition, we find that the marginal "effect" of ratings is non-linear, in that the impact of a rating downgrade on the probability of failure is larger, the weaker a bank's initial rating.

Effects of Federal Reserve Services on the Efficiency of the System for Collecting Checks in the United States: 1915-30.

This paper investigates whether the services of the Federal Reserve System improved the efficiency of the system in the United States for collecting checks relative to the efficiency of the system used by banks just prior to the formation of the Federal Reserve. There are two types of evidence that the Fed?s services improved efficiency. First, the Reserve Banks quickly became major processors of interregional checks, even though banks could have continued to use the prior payments arrangements. Second, declines in the ratios of cash to total assets of banks can be attributed to the development of the Fed?s check collection services.

Conditional Heteroskedasticity in Qualitative Response Models of Time Series:A Gibbs Sampling Approach to the Bank Prime Rate.

Previous time series applications of qualitative response models have ignored features of the data, such as conditional heteroscedasticity, that are routinely addressed in time-series econometrics of financial data. This article addresses this issue by adding Markov-switching heteroscedasticity to a dynamic ordered probit model of discrete changes in the bank prime lending rate and estimating via the Gibbs sampler. The dynamic ordered probit model of Eichengreen, Watson and Grossman (1985) allows for serial autocorrelation in probit analysis of a time series, and the present article demonstrates the relative simplicity of estimating a dynamic ordered probit using the Gibbs sampler instead of the Eichengreen et al. maximum-likelihood procedure. In addition, the extension to regime-switching parameters and conditional heteroscedasticity is easy to implement under Gibbs sampling. The article compares tests of goodness of fit between dynamic ordered probit models of the prime rate that have constant variance and conditional heteroscedasticity.

Conflict of Interest between Borrowers and Lenders in Credit Cooperatives: The Case of German Co-operative Banks

Over the last few decades, the co-operative banking sector in Germany has steadily increased its market share at the expense of other types of banks. This outcome is surprising from the standpoint of traditional economic thinking about co-operatives, which suggests that they are most appropriate for "backward" economies. We develop a model of co-operative banks that highlights the dual role ofmembers as borrowers and lenders. We show that a shift in the median (hence pivotal) member of the co-operative from predominantly a borrower orientation toward a lender orientation causes the co-operative bank to shift its policy from underpricing credit toward the provision ofcompetitively priced credit and deposit services. Together with a nationwide supporting infrastructure to capture scale and scope economies (the Verbund), the market-oriented policy ofGerman co-operative banks today allows them to compete successfully with other banking groups.

Do Bank Loan Rates Exhibit a Countercyclical Mark-up?

Based on a switching-cost model, we examine empirically the hypotheses that bank loan mark-ups are countercycical and asymmetric in their responsiveness to recessionaly and expansionary impulses. The first econometric model treats changes in the mark-up as a continuous variable. The second treats them as an ordered categorical variable due to the discrete nature of prime rate changes. By allowing the variance to switch over time as a Markov process, we present the first conditionally heteroscedastic discrete choice (ordered probit) model for time-series applications. This feature yields a remarkable improvement in the likelihood function. Specifications that do not account for conditional heteroscedasticity find evidence of both countercyclical and asymmetric mark-up behavior. Incontrast, the heteroscedastic ordered probit finds the mark-up to be countercycical but not significantly asymmetric. We explain why controlling for conditional heteroscedasticity may be important when testing for downward stickiness in loan rates.

New Evidence on Returns to Scale and Product Mix Among U.S. Commercial Banks

Numerous studies have found that banks exhaust scale economies at low levels of output, but most are based on the estimation of parametric cost functions which misrepresent bank cost. Here we avoid specification error by using nonparametric kernel regression techniques. We modify measures of scale and product mix economies introduced by Berger et al. (1987) to accommodate thenonparametric estimation approach, and estimate robust confidence intervals to assess the statistical significance of returns to scale. We find that banks experience increasing returns to scale up to approximately 0 million ofassets, and essentially constant returns thereafter. We also find that minimum efficient scale has increased since 1985.

Interbank Netting Agreements and the Distribution of Bank Default Risk

Central banks and private banks alike have advocated greater use of interbank netting agreements in recent years in order to reduce potential for transmitting economic shocks through interbank markets. This paper provides a model of an interbank payment market and shows that one sideeffect of greater netting of interbank claims is a redistribution of bank default risk away from interbank claimants toward non-bank creditors of banks, including the deposit insurer. Interbank netting agreements thus involve a trade-off between reduced interbank credit-risk exposure and increased concentration of bank default risk on other sets of bank creditors.

Why Do Banks Disappear: The Determinants of U.S. Bank Failures and Acquisitions

This paper examines the determinants of individual bank failures and acquisitions in the United States during 1984-1993. We use bank-specific information suggested by examiner CAMEL-rating categories to estimate competing-risks hazard models with time-varying covariates. We focus especially on the role of management quality, as reflected in alternative measures of x-efficiency and find the inefficiency increases the risk of failure, while reducing the probability of a bank's being acquired. Finally, we show that the closer to insolvency a bank is, as reflected by a low equity-to-assets ratio, the more likely its acquisition.

Banking and Deposit Insurance as a Risk-Transfer Mechanism

This paper models an economy in which risk-averse savers and risk-neutral entrepreneurs make investment decisions. Aggregate investment in high-yielding risky projects is maximized when risk-neutral agents bear all nondiversifiable risks. A role of banks is to assume nondiversifiable risks by pledging their capital in addition to diversifying risks. Banks, however, do not completely eliminate risks when monitoring by depositors is not perfect. Government deposit insurance that uses tax revenue to pay off depositors effectively remaining risks to entrepreneurs. Deposit insurance improves welfare because imperfect monitoring by the government results in income transfer among risk-neutral agents rather than lower production.

Technical Progress, Inefficiency and Productivity Change in U.S. Banking, 1984-1993

Numerous studies have found that US commercial banks are quite inefficient, and we find that, on average, banks became more technically inefficient between 1984 and 1993. Our analysis of productivity change, however, shows that technological improvements adopted by a few banks pushed out the efficient frontier, and that, on average, commercial banks experienced productivity gains. For banks with assets less than 0 million, however, technological improvement was insufficient to offset increased inefficiency, and thus productivity declined over the period. Our findings suggest that increasing inefficiency is reflective of an industry undergoing rapid technical change and adjustment of average firm size, but not necessarily a long-term decline.

Asymmetry in the Prime Rate and Firms' Preference for Internal Finance

This article tests for asymmetry in thebehavior of bank lending rates by testing the hypothesis that the prime rate responds more fully and quickly to increase than decreases in market interest rates. The econometric methodology used is better suited to the discreteness and rigidity of the prime rate than that of previous studies. Our results suggest that banks adjust the prime rate asymmetrically in response to change in the discount rate, the commercial paper rate, and the spread between the prime and commercial paper rates. Asymmetry in bank lending rates is implied by several explanations for the preference among small firms for internal finance. Asymmetry in bank lending rates may result from the fact that individual banks have acquired costly information which prevents their customers from responding quickly to changes in loan terms, or it may stem from a cyclical "lemons" premium resulting from informational asymmetries [Oliner and Rudebusch (1992)]. Either way, asymmetric behavior of bank lending rates, such as the prime rate, may be part of a more complete explanation of small firms? preference for internal finance.

The Bank Capital Requirement and Information Asymmetry

This paper recognizes two main factors that cause the capital requirement to affect the weighted average cost of capital and hence the investment behavior of banks: underpriced debt resulting from the deposit insurance and information asymmetry between managers and the stock market. For a bank enjoying a low cost of debt (deposits), an increased proportion of equity financing raises the weighted average cost ofcapital. When the stock market underestimates the value of a bank due to information asymmetry, equity financing is expensive. This paper finds that banks constrained by the tightened capital requirement grew slower in 1991 and that information asymmetry as well as underpriced deposits played a role in explaining the slower growth.

Explaining Bank Failures: Deposit Insurance, Regulation, and Efficiency

This paper uses micro-level historical data to examine the causes of bank failure. For state charactered Kansas banks during 19 10-28, time-to-failure is explicitly modeled using a proportional hazards framework. In addition to standard financial ratios, this study includes membership in the voluntary state deposit insurance system and measures of technical efficiency to explain bank failure. The results indicate that deposit insurance system membership increased theprobability of failure and banks which were technically inefficient were more likely to fail than technically efficient banks.

Government Policy and Banking Market Structure in the 1920s

Excess capacity, or “overbanking,” was cited by contemporaries as leading cause of bank failure during the 1920s. Many states that had high numbers of banks per capita in 1920 had high bank failure rates subsequently. This article finds that the number of banks per capita was highest in states that provided deposit insurance, set low minimum capital requirements, and restricted branching. Banks per capita declined the most over the 1920s in states where branching expanded, and in those suffering high failure rates because of falling incomes or instability caused by deposit insurance. Deposit insurance and the relative dominance of agriculture also explain the composition of state banking systems between state and federally chartered institutions.

'The Slack Banker Dances': Deposit Insurance and Risk-Taking in the Banking Collapse of the 1920s

This paper studies the effects of deposit insurance on bank behavior using individual bank data from Kansas in the 1920s. Kansas banks were severely stressed by the collapse of agricultural prices in 1920 and resulting increase in farm mortgage defaults. Because membership in the state deposit insurance system was voluntary, it is possible to compare the behavior of insured and non-insured banks facing similar exogenous circumstances. We find that deposit insurance encouraged excessive risk-taking, which helps to explain the comparatively high failure rate of insured banks. The deposit insurance fund ultimately failed to reimburse many depositors of failed banks. We find, however, no evidence of a decline in the credibility of insurance, and hence in the ability of insured banks to take excessive risks, before the system’s collapse in 1926.

Regulation and Bank Failures: New Evidence from the Agricultural Collapse of the 1920s

This article examines the contribution of government policies to the high number of bank failures in the United States during the l920s. I consider the state of Kansas, which had a system of voluntary deposit insurance and where branch banking was strictly prohibited, and find that bank failure rates were highest in counties suffering the greatest agricultural distress and where deposit insurance system membership was the highest. The evidence for Kansas illustrates how prohibitions on branch banking caused unit banks to be especially susceptible to local economic shocks, and suggests that, despite regulations to limit risktaking, deposit insurance caused more bank failures than would have occurred otherwise.

Which Banks Choose Deposit Insurance? Evidence of Adverse Selection and Moral Hazard in a Voluntary Insurance System

The sharp increase in depository institution failures in recent years has drawn attention to the moral hazard created by under-priced deposit insurance. To identify possible reforms, researchers have begun to consider alternative deposit insurance arrangements. This paper contributes to that literature by examining the deposit insurance system of Kansas, which operated from 1909 to 1929. The Kansas system had a number of regulations that were intended to limit risk-taking, and membership was made voluntary to assuage objections that insurance forces conservative banks to protect depositors of high-risk institutions. Using individual bank data, we test explicitly whether adverse selection and moral hazard characterized the Kansas system. We find that risk-prone banks were the most likely to join the system at its inception. And, using a simultaneous equation model, we find that both adverse selection and moral hazard behavior were present throughout the system?s first ten years.

Contagious Bank Runs in the Free Banking Period

In the free banking period in the United States, banks issued private banknotes without discretionary restriction of entry into banking. Previous research suggests that specific aspects of the free banking laws account for banks' difficulties, losses to noteholders, and the attendant relatively large number of banks closed. In this paper, we examine the hypothesis that contagious is: 1. the actual sequence of events in two episodes in which numerous banks closed; and 2. a statistical analysis of four episodes. The evidence is consistent with the hypothesis that contagious bank runs account of many of the banks closing. Bankers' use of measures such as restrictions of convertibility and joint guarantees was ad hoc and apparently less effective in this period than after the Civil War.


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