Interstate banking ; Branch banks ; Agricultural credit ; Bank loans ; Bank investments

Elizabeth Laderman

Gary C. Zimmerman

Ronald H. Schmidt

English

Research Papers in Economics

FRBSF WEEKLY LETTER
Number 91-30, September 6, 1991
Bank Branching and
Portfoiio Diversification
In recent months, banking powers reform has
become a major congressional policy issue. One
option under consideration would permit a bank
to operate branches in different states. The hope
is that this would enhance banks' ability to diver-
sify their assets. Potentially, this approach could
lead to consolidation of the banking industry
with a smaller number of large banks operating
national branch networks.
Would interstate branching increase bank asset
diversification? To answer this question, we can
begin by examining the historical experience of
intrastate branching. In this Letter, we focus on
the effects that intrastate branching has had on
agricultural lending. Our evidence suggests that
banks in states with unrestricted branching typ-
ically have developed more diversified loan port-
folios than similar banks in restricted states. By
extension, interstate branching could lead banks
to choose to broaden the set of industries to
which they lend. Specifically, we can expect that
banks headquartered in urban areas would .de-
vote more of their loan portfolios to agriculture,
while banks headquartered in rural areas would
concentrate less on agricultural lending.
Portfolio choice
For banks, diversification presents both benefits
and costs. The major benefit is that banks can
distribute their loans across a broad range of
customers, which helps insulate them from the
effects of individual loan defaults. By not "put-
ting all their eggs in one basket," banks can
reduce the chance of insolvency.
The costs are largely due to the increased need
for information-gathering. In particular, lending
to customers in a greater variety of industries re-
quires the bank to learn about those industries to
evaluate their loan potential. Economists usually
argue that banks specialize in evaluating and
monitoringthe creditworthiness oftheir borrowers
-borrowers whose projects and prospects can-
not be as easily evaluated by other creditors.
Banks' special, customer-specific expertise may
stem from their access to information, including
information about transactions activity, gained
from deposit relationships with borrowers. Thus,
banks may find that, despite potential diversifica-
tion benefits, it is more attractive to take advan-
tage of knowledge specific to existing customers
than to bear the cost of acquiring expertise in
new areas.
This trade-off between diversifying a portfolio
and acquiring expertise about new borrowers
and their projects also has a geographic com-
ponent. Banks may recognize the benefits of
diversification, but may find that it requires some
lending to borrowers in geographically dispersed
areas. If evaluating and monitoring distant bor-
rowers is too costly, diversification may suffer.
Effects of regulation
To the extent that it is hard to learn about and
monitor borrowers at a distance, lifting branching
restrictions enhances banks' efforts to diversify
their portfolios. Setting up a bra,nch in an area
can provide a bank with a local observation post
to gather information. For example, by having a
branch in the area, a bank may be able to learn
more about the potential returns to a local in-
vestment than could a bank outside the area. A
branch may also provide the bank with informa-
tion gained through a relatively long-term rela-
tionship with the borrower, both in the bank
and in the community. Although banks without
branches in the area may still make loans there,
their evaluation and monitoring costs will very
likely be relatively high.
Regulations limiting branching, therefore, may
tend to restrict the market area of a bank to the
region that is close to the bank's headquarters.
Thus, states that allow branching may have banks
that lend across wider markets. To the extent that
different locales in the potential market area have
different industrial structures, banks in branching
states may have more diversified portfolios.FRBSF
Evidence in agriculture
Examining agricultural lending in bank portfolios
offers one test of this hypothesis. Agriculture is
by its nature restricted to low-density rural areas.
Moreover, the nation's agricultural land is present
in both states that allow branching and those that
do not, making comparisons possible.
We examined data on lending by individual
banks taken from the Federal Reserve's "Survey
of Terms of Bank Lending to Agriculture" over
the period 1981 to 1986. Our statistical model
sought to explain the ratio of a bank's agricul-
tural loans to its total loan portfolio. Variables
to explain this agricultural share included bank
characteristics, such as its size (assets) and its
aggressiveness in lending (deposit-to-Ioan ratio).
The model also accounted for differences in the
characteristics of the agricultural economy, taking
into account average farm size, government pay-
ments to agriculture, and agriculture's share of
gross state product. Competition from other in-
stitutional lenders also was included, using the
Farm Credit System's share of total agricultural
lending in the preceding year in the bank's state
as an explanatory variable.
Finally, to get at the central point, variables were
included to indicate whether the bank was in a
restricted or unrestricted branching state, and
whether the particular bank was in an urban or
rural area.
Findings
Results from the regression analysis found that
branching restrictions were associated with im-
portant variations in bank portfolios. Moreover,
the effects of the restrictions worked in the ex-
pected direction: Banks in states that allowed
branching had more diversified loan portfolios
than similar banks in states with branching
restrictions.
Not surprisingly, urban banks had significantly
smaller portfolio shares in agricultural lending
than did rural banks, in both restricted and un-
restricted states. However, in unrestricted states,
urban banks had agricultural shares only 5.3
percentage points below those in rural areas.
Restricted urban banks, in contrast, had agri-
cultural shares 19.3 percentage points below
the portfolio shares oftheir rural counterparts.
Simple simulations indicated that eliminating
branching restrictions would boost the diver-
sification of rural and urban banks. We found
that if all other explanatory variables were held
constant and branching restrictions were elimi-
nated, urban banks would increase their agricul-
tural portfolio shares by 4.3 percentage points,
while rural banks would decrease their shares
by 9.7 percentage points.
Implications
The empirical results suggest that geographic
limitations on banking may limit a bank's ability
to diversify its lending portfolio. A more com-
prehensive branching system, therefore, may
produce a different lending pattern from the
one we now observe.
Although the model predicts a decrease in the
rural banks' agricultural portfolio share, the net
effect on agricultural lending may be positive for
two reasons. First, because urban banks in re-
stricted states hold 98 percent of total loans in
those states, urban banks' modest increase in ag-
ricultural lending predicted by the model would
swamp the decrease implied for the rural banks.
The model predicts a net increase of4.2 percent-
age points in average agricultural portfolio shares
in restricted states.
Second, branching could help agricultural com-
munities by increasing diversification and reduc-
ing costs of bank services. First, by encouraging
greater portfolio diversification, branching can
enhance rural bank (and urban bank) stability.
Because the health of many agricultural banks
is at present tied so closely to the fortunes of the
area's agricultural economy, a few bad years in
a row ~an put the bank in jeopardy. For example,
Smith (1987) found empirical evidence that
intrastate branching restrictions increase the
incidence of bank closure.
The failure of a local bank can have a serious
effect on an agricultural community. Calomiris,
Hubbard, and Stock (1986) have argued that,
since agricultural lending depends heavily on the
information a bank has acquired about the bor-rower, other banks cannot quickly step in to take
the place of rural banks that fail. In fact, they
found a statistically significant negative relation-
ship between bank failures and farm output.
Branching also may be more efficient. Encour-
aging too many banks to operate by restricting
branching may make bank costs higher than
necessary. Mergers of small banks can result in
reduced overhead and lower costs of service to
bank customers. Moreover, if rural banks have
access to broader credit markets, they may be
able to invest in loans yielding higher returns. At
present, many agricultural banks lend a sizable
portion of their assets at low rates in the federal
funds market because oftheir limited ability to
identify other, more profitable investment oppor-
tunities. Thus, interstate branching may well in-
crease the supply of agricultural loans at a given
price. Moreover, rural customers may benefit in
other ways, perhaps through increased interest
on their deposits, enhanced services, or de-
creased service charges.
Conclusions
Increased branching activity is likely to allow
banks to compile more diversified portfolios.
Current restrictions on branching appear to have
limited banks' portfolios to the industries geo-
graphically close to the bank. Specifically, an
examination of agricultural lending reveals that
banks in states that allow branching had more
diversified lending patterns than those that re-
stricted branching.
Reform that allows more branching activity
may increase loan availability to agriculture from
commercial banks. Contributing to an increase
in supply would be increased lending by urban
banks as they establish branch networks. In addi-
tion, such reform would strengthen the health of
the banking system through diversification and
possibly would lead to an increase in bank
operating efficiency.
Elizabeth laderman
Economist
Ronald H. Schmidt
Senior Economist
Gary C. Zimmerman
Economist
References
Smith, Hilary H. 1987. "Agricultural Lending: Bank
Closures and Branch Banking!' Federal Reserve
Bank of Dallas Economic Review (September)
pp.27-38.
Calomiris, Charles W, R. Glenn Hubbard, and James
H. Stock. 1986. "The Farm Debt Crisis and Public
Policy!' Brookings Papers on Economic Activity 2,
pp.441-485.
Laderman, Elizabeth 5., Ronald H. Schmidt, and Gary
C. Zimmerman. 1991. "Location, Branching, and
Bank Portfolio Diversification: The Case of Agri-
cultural Lending!' Federal Reserve Bank of San
Francisco Economic Review (Winter) pp. 24-38.
Opinions expressed in this newsietter do not necessarily refiect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Judith Goff) or to the author.•.. Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.Ollt:'6 \'J 'OJSpUPJJ UPS
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Index to Recent Issues of FRBSF Weekly Letter
DATE NUMBER TITLE AUTHOR
3/1
3/8
3/15
3/22
3/29
4/5
4/12
4/19
4/26
5/3
5/10
5/17
5/24
5/31
6/7
6/14
7/5
7/19
7/26
8/16
8/30
(91-9)
(91-10)
(91-11)
(91-12)
(91-13)
(91-14)
(91-15)
(91-16)
(91-17)
(91-18)
(91-19)
(91-20)
(91-21 )
(91-22)
(91-23)
91-24
91-25
91-26
91-27
91-28
91-29
Consumer Sentiment and the Economic Downturn
Recapitalizing the Banking System
Droughts and Water Markets
Inflation and Economic Instability in China
Banking and Commerce: The japanese Case
Probability of Recession
Depositor Discipline and Bank Runs
European Monetary Union: Costs and Benefits
Record Earnings, But...
The Credit Crunch and The Real Bills Doctrine
Changing the $100,000 Deposit Insurance Limit
Recession and the West
Financial Constraints and Bank Credit
Ending Inflation
Using Consumption to Forecast Income
Free Trade with Mexico?
Is the Prime Rate Too High?
Consumer Confidence and the Outlook for Consumer Spending
Real Estate Loan Problems in the West
Aerospace Downturn
Public Preferences and Inflation
Throop
Pozdena
Schmidt
Cheng
Kim
Huh
Neuberger
Glick
Zimmerman
Walsh
Levonian/Cheng
Cromwell
FWlong
judd/Motley
Trehan
Moreno
Furlong
Throop
Zimmerman
Sherwood-Call
Walsh
The FRBSF Weekly Letter appears on an abbreviated schedule in june, july, August, and December.

Agricultural Lending: Bank Closures and Branch Banking!' Federal Reserve Bank of Dallas Economic Review

Location, Branching, and Bank Portfolio Diversification: The Case of Agricultural Lending!' Federal Reserve Bank of San Francisco Economic Review (Winter)

The Farm Debt Crisis and Public Policy!'

Bank branching and portfolio diversification

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Bank branching and portfolio diversification

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Research Papers in Economics