58

H. Alton Gilbert

P. Alton Gilbert is an assistant vice president at the Federal Re-serve Bank of St. Louis, Dawn M. Peterson provided researchassistance,

A Comparison of Proposals toRestructure the U.S. FinancialSystem

INCh thue 1930s, comnuer-cial hanuks buave been

permitted to offer only a limnited nanuge of financialservices. At the sanue time, fir-ms enugaged in muon-

financial activities, as well as somne in financialindustries, have not been pernnitted to owmu banks.

Such restrictions were intended to limit the misk of

bank failure, to avoid conflicts of intem-est and to

prevent undue concentn-ation of financial power-.’In r-ecent years, however-, the separation between

banking and othuem- activities has been relaxedsomewhat; what’s mom-c, Congress is considering

funther relaxation, incknding expanding the power-s

fum banking orgaruizationus to underwu-ite secun’ities.

One major- meason fom’ permitting thue commonownership of banuks arid firms in other industriesis based on concern about the n-ole of banks infinancial intermediation in the future. Some bankcustomers have found cheaper sources of creditand other financial services outside thue bankingindustry. Consequently, some analysts say, restric-

tions must be relaxed if banks are to survive.’ Thepunpose of this paper is to describe sever-al majom-proposals for changing banking restrictions and to

‘These restrictions have not been applied to the ownership ofbanks by individuals. Individuals who own bank stock may ownand operate firms in any other industry. Under the Change inBank Control Act of 1978, individuals and groups of individualsacting in concert must apply to the appropriate federal supervi-sory agency for permission to acquire the stock of a bank overcertain percentages of ownership. See Spong (1985), pp. 94—95. The bank supervisory agencies may deny permission topurchasebank stock under the following conditions:(1)

(2)

(3)

The purchase would create a monopoly in any part of thebanking industry,The financial condition of the acquiring party could ad-versely affect the bank, orThe competence, experience or integrity of the proposedownership would not be in the interest of the bank’s deposi-

‘Corrigan (1987), Federal Deposit Insurance Corporation (1987)and Huertas (1986,1987).

tors.

59

exanune the concepts that undemlie these pro-posals.

CURRENT’ .RESTRICTIONS ONBANKING ACT!!/TTY

At pn’esent, the activities of feder-ally insuredcornmem-cial banks are limited essentially to ac-

cepting deposits, huolding m-elativelv low-risk secu-rities and making loans. Banking organizationsmuuay acquire firms engaged in financial activitiesthrough bank holding companies tBHCst — corpo-rations that own omue om’ nuome banks, In the BankHolding Company Act BHCA), Congress autho-rized the Fedenal Reserve Boan’d to detem-nuine whatactivities are permissible for BHCs; thuese activities,accor-ding to thue act, shouhd be “so closely n-elatedto banking as to be a proper incident thereto,”Banks genen-ally can engage in most activities thatBHCs are allowed to pursue. A major’ distinctionbetween luanks and the nonbank subsidiaries ofBHCs involves opportunities for geographic expan-sion. The nonbank subsidiaries of BHCs may have

offices throughout the nation, wher-eas nationwidebranch banking is not pem’mitted.

h3HCs are subject to the supervision of the Fed-eral Reserve, which periodically inspects them todetermine whethen- they are operating in a soundmanner and in compliance with regulations, in-cluding the capital requirements set by the Fed-enal Reserve.1 On sever-a] occasions, the FederalResemve Board has i-uled that BHCs could not un-dertake certain activities because they were notclosely related to banking, might result in conflictsof interest om nuight have subjected the BHCs togreater- risk.’

Table 1Restrictions on Credit RelationshipsBetween Commercial Banks and TheirNonbank AffiliatesRestrictions in section 23A of the Federal Reserve Act:

Luar.s by banks to ro”rharc ailihacs “usi be ‘n, y andadecuately coiratealizec

2 Tota c’odit tn any ole nonoank affiliate is lim’ted to 10perueni 01 the oan.K S capimal

3 Combined credit to a nonhar’ a1-iates -s . mite C Mr 70percem of the oar-cs capita:

4 Pjrurases by nan-cs of unsor.nU assots from qonharikaft’ . ates are forbidthn

5. Bark t~ansaction~w’th affiliates rinc.uarng :ransachonscovo’ed by Inc stntule anc ‘rarisactions specif callyexemptl are to he on terms and cnnort:omis that arccor-s-stem with sate and sound oankir’g oract’c~s

Restrictions in section 23B of the Federal Reserve Act:

1 A banks transactions with. afti’,ates mist be or’ tenirsanc undcr crcurnstances. iricludin’j credi: standaress-milar to hose oftered to nonaffilia:e compares

2 A bank ac.t:ng as a tiduc!ary shall nol ourchasesecurities ‘ssuod by an affiliate u’iless sLrch purchasesare specified n the fiducrary agreemrerlt

3 A hamik sha not purchase secur:t,es being unde’wr’tte-iby a securities atf irate

4 A oank sna. rrol state or suggest that it is responsible forIhe obligations o~its affiliates.

NOTE Legislation In 1982 removeo most of the resmrchonson transactions between comm~rcia’banks that ares,jbsioiaries of the same corporation If a corporationowns 80 percent or more ot the shares of itssubsidiary banks the only rest”iction on trar.sact-orsbetween the subsrdiary banks is that one bank maynot sell low ouality assets from another bank in thesamne organizaton. See Rose and Tailey 19821

‘Spong (1985), pp. 95—98. The major exception to this involvesthe nonbank banks, The BHCA, which gave the Federal Re-serve jurisdiction over the acquisitions of banks by corpora-tions, defined a bank as one that accepts demand deposits andmakes commercial loans. Acquisitions of institutions that didnot accept demand deposits or make commercial loans werenot subject to the jurisdiction of the Federal Reserve in itscapacity as regulator of BHCs. These limited-service banks arecommonly called nonbank banks. The Competitive EqualityBanking Act of 1987 (CEBA) closes that loophole in the law. Itplaces restrictions on the growth and activities of nonbankbanks acquired on or before March 5, 1987, and requires firmsthat acquired nonbank banks after that date to sell them orrestrict their activities to those permissible for BHCs. Thefollowing restrictions apply to nonbank banks acquired on orbefore March 5,1987:(1) They may not engage in new activities,(2) They may not market the goods or services of affiliates or

have their banking services marketed through nonbankaffiliates, except through those marketing arrangements ineffect before March 5, 1987, and

(3) Beginning in August 1988, their assets may not rise bymore than 7 percent in any 12-month period.

CEBA also imposes restrictions on the daylight overdrafts ofnonbank banks,Gilbert, Stone and Trebing (1985).

‘Volcker (1986), pp. 436—38. The following are some of theactivities not permissible for BHCs and the dates of denials forthose activities by the Federal Reserve Board: underwritinggeneral life insurance (1971), real estate brokerage (1972),land investment and development (1972), operating a savingsand loan association (1974), operating a travel agency (1976)and acting as a specialist in foreign exchange options on asecurity exchange (1986).

60

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Some banks offer financial services throughtheir own subsndrar ies 1 he Con ptm olher of theCun-mcncv determuuines which activities arc permis-snhlr for subsidiarncs of national banks, these are

gener ally r estm’nrted to activities that are permissible fom national banks themselves, In recent years,

GetS state go~ernnuemutshave alhot%ed suhsmdnanmes of~tsganftnfl U~nflw~ state-cha tered banks to engage mn a ~ariety of new

activities; among thcse arc insurance, real estateErtrrsthatenga~a Pwmsengagsuuw -nnufimuanuctat acttvt~cosntmy investment and securities underwritinga v bartks bisetta All federally insured commercial banks arc sub

usnvetyaMd sSrdnonstn lImo . . -

tm ttseba$cs asea Ohdbbuse ject to iestrnctmons on tnansa( tions with thenr affihir*s ates’ thest rcstrictions are shown in tabhe 1 Thus

for example total loans to affiliates a -e limited to

‘0 percent of the banks capital. Additional rcstric-tions apply to sales of assets to banks and pur-chases b banks of securities issucd by nonbankaffiliates or underwrittcn by securities affiliates as

ant ‘P*lrbntbatflowned well as restrictions on loan by banks to therm of-rear Qfi~ sioM*aklng ficers directors and major stockhohders.

atgannzattonsfrornlermdlruflafflates-

Ihis section describes sx p ‘oposahs for restruc-

turing the U.S. banking system. Although otherscould be included, particularly those deahing withthe cntrv of banks into specific industries, the

following proposals encompass the range of op-

tmarukssrrbpct a ownbaruhsniotanbject tions being considered in curt nt policy debates.st~rvl~hbyttu, Im upenvmsors The key features of these six proposa 5 are sumfa4ealb~lk exc~pttoSty -

s pItisors S thosabanit manLcd in table 2. Fach proposal would permitirrclSnflxercise hetdortly the banking omganiiatmons to engage in a broaderof powa eta trot des’~natedsats tange of a tivities than -urrently ahlovn,ed. Essen-mu (suctras ate tially, the proposahs allow nonbanking services to

hc offct ed thmough corporate entities affiliates or

~ga’ancentra- subsidiaries) distinct fn’om the banks themselves.trdftfttthetlnaflcraI Theme are two primuarv differences among the

proposals. Fit st, the differ on whether- to pennuit

nonfinancial firms to acquire banks or BHCs.These differences reflect conflicting views on the

Na forms Noneoblmgatnon but

I comnvtmenmto be ~ourca ~ Federal Deposit Insurance Corporation (1987), p. 106. ThissIte ~ for bank paper focuses on the issues involved in the common owner-ship of commercial banks and firms in other industries. Non-ubsidians banking firms may offer a wide range of banking services by

acquiring savings and loan associations (S&Ls). CorporationsCurrent Banksubsidies as in any industry other than securities underwriting may acquireesirrotrons o’Iruonbenk rig mis one S&L each. Regulations prohibit lending by S&Ls to their

may Itodonly nonfinancial parent organizations and restnct other types ofdestgmuated low rsic transactions that could benefit the parent organization at thetqtmtd asset expense of the S&L subsidiary. See Federal Home Loan Bank

________________________________________ Board (1986).Spong (1985), pp 55—58

62

policies necessary to avoid conflicts of interest,decreased or unfair competition among firms of-fering finaiucial services and undue concentrationof ecomuoruic resour-ces, Tluese issues have beendiscussed exteiusively elsewher’e; they are not ana-lyzed in this articlei

Second, the pm-oposals differ on the policiesnecessary to limit the risk assumed by banks, Notethat the proposals have some common featuresdesigned to limit banking risk. Each proposal intable 2 requires banking omganizations to offer’nonhanking services tlumough subsidiaries or’ affili-ates; moreover, each includes restrictions onbanks lending to their nonhank subsidiaries oraffiliates. l’hese proposals rely in part on the legalconcept of “corporate separateness,” under- whichthe creditoms of a corporation have no legal claimon the assets of a stockholder, even if that stock-holder is another com-poration. ‘I’hus, creditor-s ofthe nonbanking units of a firm that also owrus

banks would have no claim on its banks’ assets.”

Several proposals include special features tolimit the risk of bank failure that might result fromaffiliation of banks and nonbanking firms. TheHelter proposal IHeller- (1987)) r’equir-es BHCs toabsorb all losses incurred by their bank subsidi-aries; nonfinancial firms that acquire BhiCs wouldahsomb all losses incurred by their Bl’tCs. The FUICproposal (Federal Deposit Insurance Corpomation(1987)) requires bank supervisor-s to audit transac-tions between banks and their nonbank affiliatesor subsidiaries to determine wluether they ar’e

detrimental to the banks. The Corrigan pm’oposal(Corrigan (1987)) relies on direct supervision of thefirms that buy banks to limit the risk they assume.Finally, the Litan proposal (titan (1987)( requires

bamuks pumchased by nonbanking firms to holdonly low-risk liquid assets.”

A FRAMEWORK FOR AINALYZII~GTHE RISK OF BANK FAILURE

The pi-oposals for changing bank r-egulations ar-cconcem’ned with their likely effect on bank failures.This section illustrates how tlue probability of bank

failure is affected when banks and nonbankingEimms combine.

Key Factors 4ffecting the Profits andRisks oj’Gnnthining Banks andNOnbanking Firms~

If a bank offer-s nonbanking services, the effecton both the expected rate of return and the varia-bility of returns to the bank’s shareholders, as wellas the risk of failure for the bank, depend on fivefactors. Suppose a bank merges with a nonbankingfirm. One important factor’ is the average level ofexpected profits or rate of return for the nonbank-

ing service. A second factor is the “risk” associatedwith the prospective nonbanking service; misk isoften measured by the standard deviation of theprofits om- rates of meturn. A thir-d factor is the cor-relation between the profit rates of the bank and

aRose (1985).9Black, Miller and Posner (1978).

“Similar proposals have been made by Kareken (1986), Gilbert(1987), Tobin (1987) and Forrestal (1987). Tobin proposeslimiting the assets of all banks to short-term, low-risk assets.

“The factors that determine the expected value and variance ofprofits of a firm that buys a bank and a nonbanking firm can beexpressed in the following equations:

E(B + N) = E(B) + E(N),

V(B + N) V(B) + V(N) + 2COV(B,N),where F refers to expected value, V to variance, B to the profitsof the bank, N to the profits of the nonbanking firm and COV tothe covariance of the profits of the bank and the nonbankingfirm, Holding constant the covariance of the two profit streams,a higher variance in the profits of the nonbanking firm means ahigher variance in the profits of the combined firms, The vari-ance of the combined profit streams depends on the covari-ance of the two profit streams. Finally, as the size of the non-banking firm rises relative to the size of the bank, the varianceof the combined profit streams converges to the variance of theprofits of the nonbanking firm,

returns to shareholders of a firm that buys a bank and a non-banking firm and operates them under the conditions of thevarious proposals. One approach to this analysis might involveexpressing the mean and variance of the profits of the firm thatbuys the bank and the nonbanking firm in terms of the meanand variance of the profits of the bank and the nonbanking firmseparately, as indicated in the equations above, The problemwith this approach is that the distribution of returns to share-holders is not the same as the distribution of profits. In someoutcomes, losses exceed the investment of the shareholders;losses to shareholders, however, are no larger than their in-vestment in the firm, The distinction between the distribution ofprofits and the distribution of returns to shareholders is espe-cially important for this study, since the various proposalsinvolve different rules for truncating the losses to shareholders,Analysis of the mean and variance of returns to shareholdersmust be based on specific distributions of the profits of thebank and the nonbanking firm, as presented in the text, not onthe expected value and variance of the profits.

An analysis of the proposals to restructure the financialsystem involves an analysis of the mean and variance of the

63

Table 3Means and Standard Deviations of Profit Rates for Firms inFinancial Service Industries, 1975—84

Averageafter-tax Standardreturn on deviation

Industry equity (ROE) of ROE

Commercial banks 12.3°c 1 30.~

Thrift nstitutions 34 107Securities brokers 130 40Securities underwriters 16.4 57

Large investment banks on’y 21 5 7 7Life insurance uqderwrtters 13.7 23Property-casualty insurance underwriters 11.9 6 4Insurance brokers and agents 122 41

All manulactunng 13 1 20

SOURCE Litan fi987i. o.64

nonhanking firm. A fourth factor is the size of thebank relative to the nonbanking firm. The thirdand fourth factors are important because the bankmay actually reduce its risk by acquiring a non-banking firm that has a higher- coefficient of varia-

tion of profits than the bank. This possibility willbe demonstrated later’.

The fifth factor’ that must he considered is the

“synergies” (increase in profitsi involved in com-bining banking and nonbanking services in thesanue organization. Offer-ing banking and nonbank-ing services through the same firm nuay reduce the

cost of providing the services and may attract cus-tomers who value the wider’ ar-ray of services of-fer-ed by the combined bank-nonbank firm, Thesesynergies could pm’oduce profit rates that exceedthe sum of the profit rates of banks and firms inthe nonbanking industry opemating as separatecorporations.

Some Empirical Estimates of Bates qf

Return and Risk

A nurrmbei of studies have investigated the profitr’ates in banking and selected nonbank activities.”One finding, demonsti-ated in table 3, is that both

the aver-age profit rate and its standard deviationar-c lower in banking than in sever-al industries

that banks would be permitted to entei- under’ ther-ecent proposals.” Indeed, the standai-d deviationof return on equity, one measure of risk, is lowestin table 3 for- the banking irudustry. Another keyfinding of these studies is that the profit rates ofbanks are not positively correlated with the profitsof firms in many industr-ies that they would bepernutted to enter. Thus, banks could diver-sifytheir risk by entering many nonhanking industries,even if the profits of firms in those industries aremor-e variable than those of banks.

“Eisenbeis and Wall (1984) survey the studies. For more recentstudies, see Boyd and Graham (1988) and Macey, Marr andYoung (1987). There is evidence that BHCs reduce their risk byoffering nonbanking services. See Boyd and Graham (1986),Wall (1987) and Brewer (1988). The results of these studies donot indicate the effects on risk of banking institutions enteringnonbanking industries as permissible under the proposals intable 2. The nonbanking activities permissible for BHCs noware primarily those permissible for banks, The diversification ofrisk achieved by offering the nonbanking services currentlypermissible for BHCs may reflect merely geographic diversifi-cation,

“Some studies measure returns to shareholders using data onstock prices and dividends, These studies report similarpat-terns: mean rates of return and variability of returns to share-holders are higher in several of the industries that bankingorganizations would be permitted to enter than in the commer-cial banking industry. See Boyd and Graham (1988), Eisemann(1976) and Macey, Marr and Young (1987).

64

Table 4Variability of Profits of Hypothetical Firms formed through theMerger of Banks and Firms in Various Financial Industries,1962—82

Coefficientof

Item variation

Banks diofle 0 22Banks plUs savings aid loan asscciator’s 0 18Banks oiLs personal creo’t agonc Cs 0 24Banks pus bus--iess credit agencies 0 22Banks p us secLr,hos anc cornmnd:l e.s bro4ers 0 22Banks p us -fe :nsuranre 0 15Banks olus murrja; ‘nsu’ers 0 29BanKs plus insurance agents 0 15

Banks pius rcai eslate opera’o’~ard essnrs 020Banks pus subd.v,ders and cevelopers 0 20

NOTE A t.me series of lie prof1s of eacn h.ypotbetica: firm is ‘n’rnec by assLrmnq hal 75 percent oftie assets 0! Inc hyootnnt~calfirm are devotec to hankirc arid 25 oercer.l arc devo~cdtc therorbanking act v ly Tie coef~ic-er’l0 valalion is .cer:vel fo’ tile corstruc.tec ‘mc- 5cr es

SOURCE. Litan fl9Bfl. p 88

Table 4 illustrates the potential reduction in

variability of bank profits possible through mer’-gers with fir-ms that offer other- financial services.The table illustrates this with the coefficient of

variation, a measure of relative risk that is calcu-lated by dividing the standard deviation of theprofit mates by the mean. The r-esults demonstrate,using a hypothetical situation involving the rela-tive size of banking and nonbanking componentsof the firm, that the combined firm can have thesame or even lower risk than the hank itseli~eventhough risk is higher- in the nonhanking industries

The effects of per-mitting hankirug organizationsto offer- nonbanking services on the risk and re-rur-ns in banking are analyzed using two pr-ohahil-ity distributions of profits, one for a hypotlueticalhank and another- for’ a nonhanking firm. Theseprobability distr-ibutions, presented in table 5, ar-cdesigned to r-efiect the results of studies of riskand returns in banking atud various nonbankirigindustries sumnuarized above. Profit distributionsare combined in table 6 under var-ious assunup-

tions that reflect the proposals for’ r-estm-ucturirug

the 1930s, securities affiliates of commercial banksheld a large sham-e of tlue investment banking busi-ness.” In nations where commer-cial banking or-ga-

nizations nuay offer investment banking services,comnuer’cial banking om-ganizations have largeshares of the investruuent banking business.”

An Illustration

Because banks have not yet entered the variousnonbanking industries, there is little evidence onthe magnitude of the synergies involved in coruu-bining banks with other firms.’~There is evidence,

however, of svnergies for banks and selected financial activities. For example, hefor-e the separ-ation

of conunuercial banking and investment banking iru

‘~Severalstudies estimate the effects of the combination ofservices offered by banks on their costs. See Gilligan andSmirlock (1984) and Benston, et. al, (1983). The results ofthese studies are not relevant in estimating the effects of non-banking services on the costs of banks, since the data are forbanks subject to current limitations on the services they mayoffer.

“White (1986).

“Daskin and Marquardt (1983).

65

Table 5Probability Distributions of the Profitsof a Bank and a Nonbanking Firm Priorto Merger or Affiliation

BankReturn to

Outcome Probability Profits shareholdersA 001 $1U $100

B 098 10 10

01 30Nonbanking firm

Return toOutcome Probability Profits shareholders

A 005 $115 $100B 090 15C 005 125 145

NonbankingBank firm

Expoc:eo ‘eturn to sI’aro’ro aersas a pe’cenfage of capra 10 1 ~o 1575”,

~ocflic’ent0 va’iat on of returnsto sI’areholoers 6117 24637

Expected r’ss ton e FDIC SO 10

the Iinancial system described in table 2. Table 7shows the returns to shareholder-s and the cx-pected loss to the FDIC for the four cases analyzed

in table 6.

The illustration is designed to he simple. Differ-ences arnorug the four cases might change under

assumptions that would make the analysis morecomplex. For’ instance, the management of thefir-rn that buys the bank and the nonhanking firmis assumed to make no changes that affect thecapital ratios or the probability distributions ofpi-ofits. Analysis of the cases under alternativeassunuptions is beyond the scope of this paper.

The bank begins the current year wuth bookvalue of equity equal to $100. The market value ofthe hank is assumed to equal its hook value prior

to financial restructuring which pernuits tlue af-filiation of the bank with the nonhanking firnu. As

presented in table 5, the (discrete; probability dis-tributioru of the bank’s pr-ofits in the current yearhas three possible outcomes: a 1 percent chanceof a loss of $110, which would cause the bank tofail, a 98 percent chance of a pmofit of 510 (a 10percent r-eturn on equity) and a I per-ceril chanceof a profit of 5130.”

‘i’able S also presents the probability distribu-tion of profits of a nonhanking firm that, begins theyear with hook value capital of $100. The marketvalue of the nonhanking firm is also assumed ini-tially to equal 5100. The nonbanking firm is riskierthan the hank: the coefficient of variation of itsprofits is higher than that of the bank. This speci-fication was chosen to reflect the gm-eatervariabilityof pr’ofits shown in table 3 in some of the indus-tries that banking institutions wish to enter.

The effects of combining the bank and the non-banking firm in the sanue corporation are exam-ined using thr-ee indicators: the expected return toshareholders as a percent of capital, the coefficientof variation of returns to shareholders of the con-solidated firm, and the expected loss to the FDICfrom the hank’s failure. These measures are calcu-lated in table S for- both the bank and the non-banking firm as separate organizations to providebenchmarks for comparison. The distribution ofreturns to shareholders differs from the distribu-tion of profits because losses to shareholders are

limited to the amount of their initial investment intlue firm. Thus, losses to shareholders am-c limitedto $100 for the bank and $100 for the nonbankingfirm. The expected loss to the FDIC is calculatedas fbllows. The bank fails in only one of the threepossible outcomes: a loss of $110, with a chance of1 percent. The loss to the FDIC in that outcomewould be 510, since the initial capital of the hankis $100. Thus, the expected loss to the FD1C is $10(loss to FDIC) X 0.01 (probability; = $0.10.

In deriving the distribution of returns to share-

holders in table (3, one must specifi’ their invest-ment, which determines their’ maximum loss andthe denominator used in calculating their ex-pected rate of return. The shareholders’ initialinvestment is measur-ed as the book value of the

combined firms. The use of book value, net of anyaccounting goodwill resulting from the acquisitionof the bank and the nonbanking firm, provides a

“The large profit of the bank associated with the small probabil-ity might reflect the recovery on loans previously charged off aslosses or a large favorable change in market interest rates onportfolios of assets and liabilities that do not have matchedduration.

66

67

Table 7Returns to Shareholders and Losses to the FOIC Under VariousCombinations of a Bank and a Nonbanking Firm

Expectedreturn to

shareholders Coefficient of ExpectedMeans of as a variation of loss

Case combining percentage returns to to thenumber the firms of capital shareholders FDIC

1 Merger 12.51% 17754 $00125

2 Affiliahon, 1293 1 6278 01000corporateseparateness

3 Affiliation 12.88 1.6434 00050HellerprOposai

4 Affil’ation. 1293 1.6860 01100corporateseparatenessbank lends 510at zero interestrate to nonbankaffiliate

basis for speci~’ingbankruptcy. Book value alsoprovides a common denominator for comparisonsof expected rates of return in the various cases.The market value of the firm that buys the bank

and the nonbanking firm will exceed their com-bined book value. If this were not the case, thecombination of these fir-ms in the same corpora-tion would not benefit the shareholder-s.

i’he profits of tlue bank and the nonbanking firmare assumed to be statistically independent and,thus, uncorrelated. This assumption simplifies theanalysis; it is also consistent with some of the evi-dence cited pr’eviously for sever-al industries thatbanks could enter. For each outcome for theprofits of the bank, there are three possible out-comes for the prohts of the nonbanking firm, Ifcombined into one firm, ther’e would be nine pos-

sible outcomes for the retur-ns to shareholder’s ofthe consolidated firm, as table 6 illustrates.

Tables 6 and 7 ignore the existence of synergiesfiom conubining a bank with a nonbanking firm;they assume that there is no incr’ease in the jointprofits resulting fi’onu lower- costs or- a wider- arrayof services to offer customer-s. As prevrously men-tioned, it is difficult to determine the magnitude ofsuch synergies, given that such combinations have

been unlawful for many years. Such synergies, ofcour-se, must exist to make such combinationsattractive to shareholders; investors can easilyobtain the benefits of diversification by owningshares of firms with uncorrelated profits-In thispaper~however, assumptions about the size of thesynergies are unnecessary; the relevant compari-sons are made between the various cases. An in-crease in the levels of profits for each outcomewould not alter’ the differences among the fourcases examined in tables 6 and 7, unless the syn-ergies eliminate bankruptcy in all outcomes.

Merger of the Bank and theAionbanking Firm: The Simplest Case

Each proposal described in table 2 calls for’ thenew activities of banking organizations to be con-ducted thr’ough corpor’ate entities that are sepa-rate from banks. This feature of the proposalsreflects the view that the chances of bank failureand the potential loss to the FDIC would be higherif the organizations that own banks offered non-banking senjces thi-ough their- bank subsidiaries,rather than through subsidiaries that are separatefrom the banks.

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This view is not valid under all circumstances,as case I in tables 6 and 7 illustrates. In this case,the hank begins offering nonhanking services bymerging with the nonbanking firm that has theprofit distribution presented in tables. The capitalof the bank after the merger is $200. Given theunderlying profit distributions in table 5, there isonly one outcome in which the bank fails: in out-

come # I, the returns from the banking and non-banking activities yield the largest possible losses.In that outcome, the shareholders lose their totalinvestment. The bank remains in operation in allof the other outcomes. In outcomes #2 and #3,in which the losses from banking operations arelarge enough to make the bank fail if operating as aseparate corporation, the profits from the non-banking operations and the increased capital ofthe bank resulting from the merger keep the hankfrom failing.

The expected loss to the FOIC in case I dependson what happens to the liabilities of the nonbank-ing firm after the merger. Suppose the nonbankingsegment of the merged firm continues to borrowfrom the same sources it used before the merger.If the claims of these lenders are subordinated tothe claims of depositors, the merger might reduce

the expected loss to the FDIC, perhaps to zero.

In this illustration, however, the merged organi-zation converts all of its liabilities to federally in-sured deposits. If the bank involved in the mergergoes bankrupt, the FD1C absorbs losses above thecapital of $200. tn outcome # 1, because thebank’s maximum loss after its merger with thenonbanking firm is $225, the loss to the FDIC is$25. Although the maximum loss to the FDIC islarger after the merger, the expected loss ($25 X0.0005) is actually smaller after the merger (com-pare tables S and 7).

The effects that a merger have on the possibilityof bank failure and the expected loss to the FD1Cdepend on the size of the nonbanking firm relativeto the bank. To illustrate, suppose the bankmerges with a nonbanking firm whose distribution

of profits is 10 times as large for each outcome asthat presented in table 5 and whose capital is$1,000. In this case, which is not shown in the

table, the expected loss to the FDIC would he$2.04, much larger than the expected loss shownin table 7. Thus, in considering a restructuring of

the financial system, the size of the bank relativeto the nonbanking firm is an important determi-nant of the expected loss to the FDIC.

4fflhiation qfa flank with aNonbanking Firm

If banks comnbine tvith nonhanking (irms, oneway to limit the FDIC’s expected loss is to requirethat banks remain separate corporations withintheir parent organizations and limit FDIC insur-ance only to the deposit liabilities of the banks.Within such structures, the principle of corporateseparateness would prevent the nonbanking firm’screditors fi’om claiming the assets of the bank.

The risk and return characteristics of a holdingcompany that buys the bank and the nonhankingfirm are presented in case 2. Under this case, la-belled affiliation, corporate separateness,” lossesto shareholders of the holding company resultingfrom losses by the nonbank subsidiary are limitedto the capital of the nonbank subsidiary. The bankdoes not rescue the nonbank subsidiary by ab-sorbing the additional losses. In turn, if the bankhas losses that exceed its capital, the nonbanksubsidiary does not rescue the hank by absorbingthe additional losses. There is assumed to be nolending among units of the holding company. Theholding company lends to neither the bank northe nonbank subsidiary, amid the bank lends noth-ing to the nonbank affiliate. The nonbank affiliateborrows, instead, from nonaffiliated lenders; theliabilities of the bank are covered by FDIC insur-ance.

The expected return to the shareholders ishigher and the variability of returns is lower incase 2 than under a similar combination of firmsarranged through a merger. Thus, the sharehold-ers benefit more from a combination of the bankand the nonbanking firm as aftiliates of a holdingcompany than through the merger of these firms.

The benefit to the shareholders, however, comespartly at the expense of the FDIC. The FDIC’s ex-pected loss is the same in case 2 as in the ben-

chmark case in table S but higher than under themerger. tinder affiliation and corporate separate-ness, the outcomes in which the FUIC is exposedto losses are determined by the probability distri-bution of the hank’s profits. Under the mergerillustrated in case I, in contrast, losses in out-

comes # 2 and # 3 that would make the bank failare absorbed by the profits of the nonbank seg-ment of the merged firm and the capital contrib-uted by the nonbanking unit. Under affiliation and

corporate separateness, however, the expectedloss to the FOIC does not depend on the size ofthe bank relative to its nonhank affiliate.

69

IMPLICATIONS FOR THEPROPOSALS

Merger or 4ffiliation

The cases in tables 6 and 7 indicate that, undersome conditions, the risk of F’IJIC loss would belower if a bank engages in a nonbanking activitydirectly, rather than through affiliation with a non—banking firm. In considering proposals for’ finan-

cial restr’ucturing, therefore, it is unnecessary toprohibit the direct offering of nonhanking services

through banks under’ all circumstances.

The Financial Services HoldingCompany (FSHC) Proposal

The proposals by the Association of Bank Hold-ing Companies (LaWar’e 1987)) and the Associa-tion of Reserve City Bankers (1987) would permitFSI-ICs to acquire banks as subsidiaries under thecondition of affiliation and corporate separate-ness. The bank could not use its assets to rescue a

failing nonbank affiliate, and the FSI-JC would nothe required to rescue a failing hank.

A comnparison of case 2 in table 7 with table 5shows how the formation of FSHCs can affect riskin banking. Affiliation of a hank with a nonbankingfirm reduces the probability that the hank will failonly if affiliation yields synergies that raise theprofits of the bank for each possible outcome.Thus, affiliations between banks and nonbanking

firms that facilitate diversification of risk for share-holdems of banking firms reduce the probability ofbank failure and the expected loss to the EDIC

on/v if there are synergies from combining bankingand nonhanking firms in the same organization.

The Heller “Double liEnbreila”Proposal

The distribution of returns to shareholders un-der the BelIer (1987) proposal is presented under

case 3 in table 6. The implications of this proposalcan he illustrated by comparing the distribution ofreturns to shareholders under various outcomesin cases 2 and 3. Under the Heller proposal, the

losses of the hank and nonbank subsidiary in out-come # 1 absorb all of the capital of the holdingcompany. The FDIC has a loss of $10 in that out-come, the amount by which the loss of the hankexceeds its capital. In outcome # 2, the bank has aloss that exceeds its capital, but the holding com-

pany is required to cover that loss, drawing on itspmofit of $15 from the nonbanking subsidiary andits capital. The holding company also covers the

large loss of the bank in outcome # 3. In outcomes# 4 and # 7, in contrast, the holding companydoes not absorb all of the losses of the nonhankingsubsidiary, Instead, the nonhanking subsidiarygoes bankrupt. The holding company writes off itsinvestment of $100, and nonaftiliated lenders ab-sorb the additional loss of $15 in each of theseoutcomes.

The minimum level of synergies necessary tomake combinations of banks and nonhanking

firms attractive to investors is higher under theI-teller pr’oposal than under’ the NI-IC proposal.The diversification of risk illustrated in case 2could he achieved through a mutual hind thatbuys shares in firms in banking and nonbanking

industres. Any synergies would make the share-holders’ expected rate of return higher with thebank and nonbanking firm combined in the finnunder affiliation and corporate separateness thanthrough a mutual fund. To make combinations ofbanks and nonbanking firms under the Hellerproposal attractive to shareholders, synergieswould have to exceed a level necessary to com-

pensate the holding company for the expectedcost of bailing out the failing bank subsidiary.

The synergies necessary to make the affiliation

of banks with nonbanking firms profitable underthe Heller proposal would be different for each

potential combination of firms. For case 3, thesvnemgies would have to raise the returns to share-holders by $0095 to make them equal to the ex-pected returns to shareholders in case 2, and even

more to compensate shareholders for the highervariability of returns in case 3.

The Corrigan Proposal

Corrigan (1987) assumes that the methods ofinsulating banks built into the proposals for FSHCswill be ineffective. This view is based on evidencethat BHCs are integrated organizations that have

used all of their resources, including those of theirbank subsidiaries, to support any nonbank subsid-iary in danger of failing. Corrigan also expressesconcern that, in approving the acquisition of

banks by nonbanking firms, the federal supeivi-sory authorities will extend the federal safety netto the parent organizations themselves.

The Effects of Loans to Nonbank Affiliates onStockholder Wealth — The Corrigan proposalreflects these views on the relationship betweenbanks and their parent organizations. Case 4 intables 6 and 7 examines whether such concernsreflect rational, profit-maximizing behavior. The

70

Corrigan proposal assumes that firms are willingto risk the assets of their bank subsidiaries to aidtheir’ nonbank subsidiaries. One way for a holdingcompany to do this is to allow the bank to lenddirectly to the nonbank subsidiary. To illustratethis, the bank in case 4 lends $10 to the nonbankaffiliate at a zero interest rate, thus subsidizing thenonbank subsidiary at the expense of the bank.

Several assumptions have been made to derivethe probability distributiomi of returns for share-holders of the holding company. First, the bankloan is assumed to be subordinated to other debtof the nonbank affiliate. tf the nonbank affiliategoes bankrupt, therefore, the bank absorbs thefirst $10 of losses to creditors. Second, the interestrate on riskless assets is assumed to be 5 percent.The distribution of profits for the bank is derivedby subtracting $0.50 from the profits for each pos-sible outcome presented in table 5; this reductionreflects the opportunity cost of foregoimigan alter-native investment of $10 at the riskless rate.

The nonbank subsidiary saves $1053 in interestexpense on the $10 it borrows from the bank; thisis the amount that a risk-neutral lender charges tocompensate for the risk-free rate of 5 percent andthe 5 percent chance of losing the $10 principaland foregoing the interest income if the nonbank-ing firm goes bankrupt.’8

The effects of this loan on the distribution ofshareholders’ returns are illustrated in table 6under case 4. In outcomes # 1, #4 and # 7, thebankruptcy of the nonbanking firm imposes an

additional loss of $10 on the bank. In outcome # 1,

in which the bank has its largest losses, the FDICabsorbs a loss of $20.50 ($10 loss from the underly-ing distribution in tables, $0.50 loss of interestincome on the loan to the nonbank affiliate and$10 loss on the loan to the nonbank affiliate).

The cost saving by the nonbank affiliate due tothe zero interest loan from the bank raises thereturns to shareholders by $1053 in all outcomesexcept those in which the nonbank affiliate goesbankrupt. The return to shareholders is $0.01higher in case 4 than in case 2; this difference is

not large enough, however, to raise the expectedrate of return in table 7 by I basis point. The im-portant difference between the distributions ofreturns in case 4 and case 2 is that the coefficientof variation of the returns is higher in case 4. Thus,it is not in the shareholders’ interest to have theirbank lend to its nonbank subsidiary, even at asubsidized rate. Such loans make their returnsmore variable.

Typically, bank supervisors would make such aloan even less attractive to the shareholders. Be-cause the loan to the nonbank affiliate raises the

expected loss to the FDIC, bank supervisors wouldrequire the bank to maintain a higher capital ratio.Though the bank could raise its capital ratio byreducing its total assets while keeping its capital

unchanged, the asset reduction would reduce thelevel of profits for each possible outcome the bankfaces.

This analysis is consistent with evidence thatfew banks make loans to their nonbank affiliatesup to the limits allowed by regulation. Rose andTalley (1983) exannne transactions among affiliatesof 224 of the 229 BHCs that filed reports with theFederal Reserve from the fourth quarter of 1975

through the fourth quar’ter of 1980. In 1980, 27percent of the BHCs had no transactions amongaffiliates. Among the 16 BHCs in which the banksubsidiaries made larger loans to the nonbank

affiliates than the nonbank affiliates made to thebanks, loans to the nonbank affiliates in 1980 wereonly 1.3 percent of the capital of the bank subsidi-aries.

Banking Risk under Assumptions Other ThanProfit Maximization — The distribution of returnsin cases 2 and 4 reflect the assumption that, if thebank does not lend to the nonbank affiliate, theaffiliate’s bankruptcy does not affect the bank’sprofits. In a few cases, however, the bankruptcy ofanonbank subsidiary of a holding company hasinduced depositors to withdraw their depositsfrom the bank subsidiary.’°The management of aholding company, therefore, might justify loansfrom a bank subsidiary to a nonbank affiliate as away to prevent the nonbank subsidiary from going

tmThe interest rate that the nonbank affiliate would pay to borrowfrom a nonaffiliated lender is determined by calculating the ratethat would make the expected return on such a loan equal tothe risk-tree interest rate. Let rI be the interest rate on the loanand rs the risk-free rate. In lending $10 to the nonbank affiliate,there is a 95 percent chance of collecting the principal plusinterest at the rate rI and a 5 percent chance of losing theprincipal and collecting no interest. The expected returns onthe alternative investments are calculated as follows:

rl / $10 / 0.95 — $10 / 0.05 = rs / $10.If rs is 5 percent,

rl = [0.05 + 0.05] + 0.95 = 0.1053.‘9Cornyn, et. al. (1986).

71

bankrupt and thus make depositors less con-cerned about the safety of their deposits. In thiscase, the costs of bailing out the nonbankimig sub-sidiary might be less than the cost of adverse reac-tion by depositors.

There have been several cases in which the

management of a BHC used the resources of abank subsidiary to aid a nonbank affiliate in dis-tr’ess. In the mid-1970s, for example, the holdingcompany that owned the l-tamilton National Bankof Chattanooga, Tennessee, arranged for the bankto buy low-quality mortgages from a mortgagebanking affiliate. The mortgage purchase was animportant factor that led to the failure of thebank.” In October 1987, to cite another case, theContinental Illinois National Bank made a loanthat exceeded its limit for loans to one customerto a subsidiary that deals in options. The subsidi-ary suffered a large loss after the sharp fall in stockprices that month.

The rationalization behind bank loans to bailout the nonbank affiliate overlooks an alternativethat might be more favorable to the shareholdersof the holding company: let the nonbank subsidi-ary go bankrupt and sell the bank to anotherparty. Losses to the holding company would belimited to its investment in the nonbank subsidi-ary, with nonaffihiated lenders forced to absorbany additional losses. If potential bidders are con-

cerned that the bank made loans to the failingnonbank affiliate or in some way assumed respon-sibility for the debts of that affiliate, the FDICcould facilitate the sale by offering to reimburse

the winning bidder for any losses resulting fromthe failure of the nonbank affiliate.

Management of the holding company may pre-fer to have the bank absorb the losses necessary tobail out the failing nonbank affiliate, rather thansell the bank, which will result in the loss of their’jobs. It may be in management’s interest to ar-range for the bank to lend to the nonbank subsidi-ary and pray that some favorable outcome helpsthe holding company remain solvent. The possi-bility of such action is why government supemvi-sors must remain aware of any financial problemsin firms that own banks and must subject the banksubsidiaries of those firms to particularly closesupervision.

The analysis in tables 6 and 7 of a bank lendingto its nonbank affiliate is based on the assumptionthat the loan is used for legitimate business pur-

poses. Loans from a bank to a nonbank affiliate, ofcour’se, could he made for fraudulent purposes.Suppose a bank is permitted to make a loan of anyamount to an affiliate. One method of stealingfrom a bank would he to buy the bank through aholding company, arrange for a loan that ex-ceeded the investment of the holding company inthe hank and disappear with the proceeds of theloan.

The potential for fraud indicates that it may be

prudent to prDhibit loans to affiliates that exceedthe capital of a bank. This pr’ohibition would notprevent all forms of fraud in banking but its viola-tion would indicate to the bank supervisors whena bank is vulnerable to this type of fraud. It is alsopr’udent to screen the background of those whobuy banks through holding companies, as thefederal bank regulatory agencies do when individ-uals buy banks.

‘rhe FDIC (1987) proposal calls for greater au-thority to audit the terms of any loans banks maketo affiliates or subsidiaries. This proposal does notindicate what bank examiners would look for insuch audits. Audits to detect fraud would be ap-pr’opriate.

The Safe Bank Proposal

The so-called safe bank pr’oposal (Litan 1987)) isintended to reduce the expected level and stand-ard deviation of profit rates of banks subject to the

safe bank” asset restrictions. As the appendixindicates, for each $100 of assets shifted from busi-ness loans to Treasury bills, the revenue of the safehank would decline by $1.26. The asset limitationsfor safe banks maybe so restrictive that theywould prevent many affiliations of banks withnonbanking firms that would promote diversifica-tion or benefit society through synergies.

One way to evaluate the safe banking proposal isto compare the size of the synergies necessary tomake bank acquisitions profitable for nonbankingfirms to the syner-gies necessary under alternativeproposals. Suppose the hank had loans of $600.” Ifthe bank becomes a safe bank by reinvesting the$600 in Treasury bills, its revenue falls by $7.56. It

“Ibid., p. 186.“Suppose the bank has a capital~to~assetratio of 10 percent.

For all federally insured commercial banks, the average ratio ofloans to assets is about 60 percent. Thus, $600 is a reasonable

level for loans of the hypothetical bank with capital of $100 anda 10 percent capital ratio.

72

must, however, continue to pay competitive inter-est r-ates on deposits after becoming a subsidiaryto avoid a decline in its deposits. Thus, synergiesfrom the operation of the bank as a subsidiarymust be worth at least $7.56 to the holding com-pany. This amount can be compared to the syner--gies necessary to make the acquisition of a banksubsidiary profitable under the Heller proposal,which is $0095 for the case examined above.

This lar-ge difference reflects the fact that thesafe bank proposal imposes a significant opportu-nity cost on a nonbanking firm that buys a hankunder each possible outcome. The Helier pro-

posal, on the other hand, imposes a loss on thenonbanking firm under- an unlikely outcome —

the failure of the bank subsidiary. These compari-sons suggest that fewer combinations of bankingand nonbanking firms that would promote diversi-fication of risk and, possibly, mor’e efficient use ofresources would be viable under the safe bankproposal than under- the Heller proposal.

CONCLUSIONS

Several barriers separ’ating banking from otherindustries have been removed in recent years,while Congress debates a more complete restruc-turing of the financial system. Much evidenceindicates that banking organizations could diver-si~yrisk by affiliating with flr’ms in a wide variety ofother industries, even those with more variableprofits than the banking industry. ‘rhis paper illus-trates the potential for risk diversification through

the common ownership of a hypothetical bankand nonbanking firm.

The illustration has several implications forcurrent proposals for restructuring the financialsystem. Banks ar-c not necessarily made safer byrequiring that all nonbanking activities be con-

ducted through separate subsidiaries. On the con-trary, banks maybe less vulnerable to failure ifsome nonbanking activities are offered throughthe banks directly. Moreover, the expected loss offederal deposit insurance funds may be lower

even if the nonbanking activities are financedthrough insured deposits.

The major proposals for restr’ucturing the finan-cial system would permit firms in various indus-tries to buy banks and operate them as separate

subsidiaries. Some of the proposals build in safe-guar-ds to prevent nonbanking firms from usingthe resources of their bank subsidiaries in waysthat would increase both the chance for bank fail-ure and the expected loss of the federal deposit

insurance funds. These r-estrictions are based oruthe presunuption that, without such safeguards,nOnbanking firnus would use the resour’ces of theirbank subsidiaries to benefit their’ nonharuk subsidi-

aries.

The analysis in this paper- indicates that theshareluolders of a holding company generally donot benefit by luaving their bank subsidiary lend ata subsidized interest rate to the nonbank subsidi-ary. In fact, shareholders are made worse off bysuch transactions because the holding companyprofits become more variable. Tr-ansactions thatbenefit nonbank subsidiaries at the expense ofhank subsidiaries do not increase the sharehold-ers’ wealth. The greatest danger in banks lendingto affiliates involves management of holding com-panies attempting to save their jobs by bailing outnonbank subsidiaries and fraudulent schemes tosteal from banks through loans to affiliates.

Two of the proposals place special corustraintson the nonbanking firms that buy banks to limitthe risks of bank failure. One proposal requiresthat the holding companies absorb all losses in-cur’red by banks, up to the holding company’stotal capital. The other proposal requires the banksubsidiaries of nonbanking firms to hold only low-risk liquid assets. Both proposals raise the level ofsynergies necessary to make the acquisition ofbanks by nonbanking firms profitable. Of thesepr-oposals, the safe banking proposal is the morerestrictive. Some consolidations of banking andnonbanking finns that would yield social benefitsin the form of higher’ profits and reduced variationin stockholder returns would not be attractive toshareholders under the safe banking proposal hutwould be attractive under- other pr-oposals.

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74

AppendixThe Opportunity Cost Of Holding Safe Assets

The safe bank proposal Litan 1987)) would putthe bank subsidiaries of nonhanking firms at adisadvantage in competing for deposits by restrict-ing the r’eturn oru their- investments. This disadvan-tage could be offset slightly by waiving depositinsurance premiums for’ the subsidiaries of non-banking firms. Under the requirements for holdingonly safe assets, the subsidiaries of nonbankingfirms would not expose the federal deposit insur-ance funds to potential losses; therefore, an argu-ment could be made for exempting “safe” banksfrom deposit insurance premiums.

The opportunity cost of investing in Treasury

securities instead of loans is estimated using datafrom the functional cost analysis program of theFederal Reserve. A change in the composition of abank’s assets affects its interest revenue and ex-penses. The functional cost data includes informa-tion on interest income and expenses allocated tovarious categories of loans, as well as expensesinvolved in purchasing and holding securities,Table Al indicates that the gross yields on loansalmost always exceed those on three-month flea-sury bills. Net yields on loans, which reflect ex-penses and losses, are lower’ than the net yieldson Treasury bills in some years for mortgage andinstallment loans.

N

TaSAI\ N

Gross andNetYields on BankAS*etsWeasc~iirN ~ intutent tmnSe and

N ‘N NrrotgeN ‘N ‘1~fls o1hetIOans~\~ar \!Gt Gr 1W

1072 46 4NQI% 302% 788% tar 10199’ ~ S tA 5550197tN 9~ ~1M 688 N8i 7)35 ~SN465NNN$44 ~1N\

\NN 1974N M’N \Tha\ N77~ 37N 7/iT Qvy~t9GNN ~ \N9Q9 N

~t975~ ~9&~ 584~. sw~‘N ~ 36 N GiN NQ5/j \sa~ ~ 7-tij978 IOUNN 499-N ~4SN ff3~NN 746~ 1111 89$ a22~ èsoI977~ ION N~27N~S1INN a4Nt8tNlios~N71NN UtN M6

Wa 85/ 122 N’N7fl~N N 6~&~N N Tnd. \1I\43 N ~aoz \N\Ø67

1979 SN 00* 9,8S~ NeSN NC8SN 1 00 NB4INN IflSN to~esN1s80~ ~e ~ 128\tQ\O1 2~ 1~9Q~ >11 ~ sjN ~

~ fl8~ 83 i4t~3 S lOS 981N 14/0O/NNOO4NIU 14M8c18 tO60~\Th54 Na$4N 445 NS&7 DOGN’NN1496 ~it3s

NNI9SS S &uS~ NM? ‘102 9NS~ ~4t~tO7N ~93\~ 9S1954N 82 9~8ØNN t43 14t~ ft 1489 Nfl1óN M2NN 103419*5 N8’~ N 48\7N1 ISO 1028 341 1130 891N

NI9Ø5NNN75N 595 575 tt2t\NN85b 250 9NNiIZIN/t3/NNN

N NNNNNNNNNNNNN N N N \N

NOT~~ Ot~àiIsetsdSe~rer~t}tN\~ ltjnctønal Cost attGtifl*59dtttL ThG!iØatâSrttbr 15 bnnlçswtio$ assets. reeferIran. N N

~ $2S~S~QfllheSeCe b4~tndtcaiS1bq~umbe of hanksttb~tsS Me4e~tb5repotfedNdata facIth 1nvssivnan~actmyS TheNchorce this i~ssttize~cat~er’yInthotww.tronaftt~staccetintsug eØ0tt5~sbased s theassuttipsa thattè safe banSo*!~Ied

elseflcØMrtangSrrs*outdfendtflave aanwdpl$rS4 fIlet N~ N

~y~efd~qhSffiotê~tstntents~tthe ss~yrSd~1ottspensostO maku nc(s1Sn9 NN N N

N N N N N N N and loisreartt Sblypes~ofbins t~sg s/yields oTm/neasNufy bft~atet~ N N N N N N

N N N N*nnm4~tnag~SQyrelds~rujhres-montt~Tree&utyklks new*sUes. styaIdsdlkTt& in N N

N N ‘N N N N taarnre grassyi&dsjnrrrus the1051$ otbuyrn~andSdrngffl~(estrnalSpeE*1tar~ N

‘N N N uWHSsbTnttn th5NIIS1CILOS LsccOuf~ dot Undenhe sat bankNprcposa S~banks N N NN N N N ~O bh9fl8In1t5$Ut~$0CotMeStat the totlfl lenti ascot ties haS’s aS’ NN N NNNN’N N

N NN pttapd9ssa7lt~fOti& uSgstheyiil~eñsbomtf~NT1hSury~’N N N N

N SMSSS~S~n*andtSSeS, N~ N N N NN N N N N N NN N N N NN N N’NN N~ /‘N NNNN N N ‘N ,NN NN N N ‘N N

Table AZ isolates the comparisons between netyields on ‘Treasury bills and those on three catego-des of loans. Net yields on mor’tgages and install-ment loans tend to fall below the net yields onTreasur bills in periods of sharp increases in

75

interest rates. The most stable spread is that be-tween the net yield on commercial and otherloans and the net yield on Treasury securities. Onaverage, banks lose $1.26 in net income before

income taxes per dollar’ tr-ansferi’ed from commer-cial loans to Treasury bills.

TabIeA2Sacrifice of Income Before Income Taxes per $100 Dollars ofLoans Shifted to Treasury Bills