The views expressed in these papers are solely those of the authors and should not be interpreted as reflecting the views of the Federal Reserve Bank of Philadelphia or Federal Reserve System.

96-1: Bank Equity Stakes in Borrowing Firms and Financial Distress by Mitchell Berlin, Kose John, and Anthony Saunders

The authors derive the optimal financial claim for a bank when the borrowing firm's uninformed stakeholders depend on the bank to establish whether the firm is distressed and whether concessions by stakeholders are necessary. The bank's financial claim is designed to ensure that it cannot collude with a healthy firm's owners to seek unnecessary concessions or to collude with a distressed firm's owners to claim that the firm is healthy. To prove that a request for concessions has not come from a healthy firm/bank coalition, the bank must hold either a very small or a very large equity stake when the firm enters distress. To prove that a distressed firm and the bank have not colluded to claim that the firm is healthy, the bank may need to hold equity under routine financial conditions.

96-2/R: Bank Capitalization and Cost: Evidence of Scale Economies in Risk Management and Signaling by Joseph P. Hughes and Loretta J. Mester

The authors amend the standard cost model to account for financial capital’s role in banking. The cost function is conditioned on the level of capital, but the authors model the demand for financial capital so it can serve as a cushion against insolvency for potentially risk-averse managers and as a signal of risk for less informed outsiders. Scale economies are then computed without assuming that the bank chooses a level of capitalization that minimizes cost. The authors find evidence of substantial scale economies and that bank managers are risk averse and use the level of financial capital to signal the level of risk. 

96-3: Evaluating McCallum's Rule When Monetary Policy Matters by Tom Stark and Dean Croushore

This paper provides new evidence on the usefulness of McCallum's proposed rule for monetary policy. The rule targets nominal GDP using the monetary base as the instrument. We analyze the rule using three very different economic models to see if the rule works well in different environments. Our results suggest that while the rule leads to lower inflation than there has been over the last 30 years, instability problems suggest that the rule should be modified to feed back on the growth rate of nominal GDP rather than the level.

96-4: Capital Requirements and Rational Discount Window Borrowing by Sherrill Shaffer

When banks face capital regulations and stochastic deposit supply, their decisions to borrow at the discount window will be affected by a broader range of variables than previous theoretical and empirical studies have recognized. Moreover, those decisions can respond discontinuously to changes in market parameters and to the form of rationing rule by which the discount window is administered. Risk aversion can complicate these linkages considerably, even causing some banks to prefer a positive discount rate that may exceed the actual level.

96-5: Speculative Investor Behavior and Learning by Stephen Morris

As traders learn about the true distribution of some asset's dividends, a speculative premium occurs as each trader anticipates the possibility of reselling the asset to another trader before complete learning has occurred. Small differences in prior beliefs lead to large speculative premiums during the learning process. This phenomenon helps explain a paradox concerning the pricing of initial public offerings. The result casts light on the significance of the common prior assumption in economic models.

96-6: Consumption, Stock Returns, and the Gains from International Risk-Sharing by Karen K. Lewis

Standard theoretical models predict that domestic residents should diversify their portfolios into foreign assets much more than observed in practice. Whether this lack of diversification is important depends on the potential gains from risk-sharing. General equilibrium models and consumption data tend to find that the costs are small, typically less than 0.5 percent of permanent consumption. On the other hand, stock returns imply gains that are several hundred times larger. In this paper, the author examines the reasons for these differences and finds that the primary differences are due to (a) the much higher variability of stocks, and/or (b) the higher degree of risk aversion required to reconcile an international equity premium. Furthermore, contrary to conventional wisdom, treating stock returns as exogenous does not necessarily imply greater gains.

96-7: Does Foreign Exchange Intervention Signal Future Monetary Policy? by Graciela L. Kaminsky and Karen K. Lewis

A frequently cited explanation for why foreign exchange interventions affect the exchange rate is that these interventions signal future monetary policy intentions. This explanation says that central banks signal a more contractionary monetary policy in the future by buying domestic currency today. Therefore, the expectations of future tighter monetary policy make the domestic currency appreciate, even though the current monetary effects of the intervention are typically offset by central banks. Of course, this explanation presumes that central banks, in fact, back up interventions with subsequent changes in monetary policy. In this paper, the authors empirically examine this presumption.

96-8: Money and Finance with Costly Commitment by Satyajit Chatterjee and Dean Corbae

The authors develop a variant of Townsend's turnpike model where the trading friction is related to a commitment problem rather than spatial separation alone. Specifically, expenditure on financial services is necessary to ensure commitment. When commitment is costless, the equilibrium allocation is equivalent to that from an Arrow sequential markets equilibrium. When commitment is prohibitively expensive, the allocation is similar to the Townsend equilibrium. The authors use numerical examples to study the consequences of costly commitment for coexistence of money and credit, asset pricing, welfare implications of currency and variations in its growth rate, and the relationships between income and financial development.

96-9/R: Efficient Banking under Interstate Branching by Joseph P. Hughes, William Lang, Loretta J. Mester, and Choon-Geol Moon

Nationally chartered banks will be allowed to branch across state lines beginning June 1, 1997. Whether they will depends on their assessment of the profitability of such a delivery system for their services and on their preferences regarding risk and return. The authors investigate the probable effect of interstate branching on banks' risk-return tradeoff, accounting for the endogeneity of deposit volatility. If interstate branching improves the risk-return tradeoff banks face, banks that branch across state lines may choose a higher level of risk in return for higher profits. The authors find distinct efficiency gains due to geographic diversity.

96-10: Exchange Rates and International Relative Prices and Quantities in Equilibrium Models with Alternative Preference Specifications by Elvan Ozlu, Don Schlagenhauf, and Jeffrey M. Wrase

Dynamic open economy models with time-separable, deterministic utilities fail to account for observed dynamics of exchange rates and international relative prices and quantities. This paper examines the ability of extensions of existing open economy models to account for exchange rates, international relative prices, and international trade quantities. The extensions involve preferences with taste shocks and nontime-separable utilities in habit persistence form. Quantitative properties of calibrated versions of the models are examined in light of time series properties of key international variables.

96-11/R: Measuring Efficiency at U.S. Banks: Accounting for Heterogeneity Is Important by Loretta J. Mester

Estimates of bank cost efficiency can be biased if bank heterogeneity is ignored. The author compares X-inefficiency measures derived from a model that constrains the cost frontier to be the same for all banks in the nation and a model that allows the cost functions and error terms to differ across Federal Reserve Districts. The author finds that the data reject the single cost function model; X-inefficiency measures based on the single cost function model are, on average, higher than those based on the separate cost functions model; the distributions of the one-sided error terms on which X-inefficiency measures are based are wider for the single cost function model than for the separate cost functions models; and the ranking of Districts by the level of X-inefficiency differs in the two models. The differences in efficiency across Districts reflect more than just differences in bank size, geographic size, or population of the Districts. These results suggest that it is important when studying X-inefficiency to account for differences across the markets in which banks are operating and, more generally, that since X-inefficiency is, by construction, a residual, it will be particularly sensitive to omissions in the basic model.

96-12: Retail Pricing of ATM Network Services by James J. McAndrews

This paper develops a model of wholesale and retail fee-setting for automated teller machine (ATM) network services, and comparative statics results are derived. Retail ATM fees are shown to be dependent on the demand-side network effect and economies of scale in production of network services. These, in turn, are functions of the size of the ATM network. Survey data on bank fees are linked with the bank's probable ATM network membership, and the retail ATM fees are regressed on ATM network size and other variables in a reduced-form estimation. The results suggest that both network effects in demand and economies of scale influence retail ATM network service fees, with economies of scale becoming dominant for the largest ATM networks.

96-13: Common Trends and Common Cycles in Regional Per Capita Incomes by Gerald Carlino and Keith Sill

Cyclical dynamics at the regional level are investigated using newly developed times-series techniques that allow a decomposition of aggregate data into common trends and common cycles. The authors apply the common-trend/common-cycle representation to per capita personal income for the eight BEA regions using quarterly data for the period 1948:1-93:4. Their analysis reveals considerable differences in the volatility of regional cycles. Controlling for differences in volatility, the authors find a great deal of comovement in the cyclical response of four regions (New England, Mideast, Great Lakes, and Southeast), which they call the core region, and the nation. The authors find some evidence of comovement of the Plains, Rocky Mountain, and Far West regions and the nation, but to a much lesser extent than the comovement among the core regions and the nation. Finally, the cyclical response of the Southwest region is strongly negatively correlated with that of all the other regions and the nation.

96-14: Safety in Numbers? Geographic Diversification and Bank Insolvency Risk by Joseph P. Hughes, William Lang, Loretta J. Mester, and Choon-Geol Moon

The Riegle-Neal Interstate Banking and Branching Efficiency Act, passed in September 1994 and effective June 1, 1997, will allow nationally chartered banks to branch across state lines. This act will remove impediments to interstate expansion and permit the consolidation of existing interstate networks.

What will be the impact of this legislation on bank performance and bank safety? Removing impediments to geographic expansion should improve the risk-return tradeoff faced by most banks. However, this paper argues that economic theory does not tell us whether an improvement in the risk-return tradeoff will lead to a reduction in the volatility of bank returns or in the probability of insolvency.

The authors investigate the role of geographic diversification on bank performance and safety using bank holding company data. The authors find that an increase in the number of branches lowers insolvency risk and increases efficiency for inefficient bank holding companies; an increase in the number of states in which a bank holding company operates increases insolvency risk but has an insignificant effect on efficiency. Branch expansion raises the risk of insolvency for efficient bank holding companies, while an increase in the number of states has an insignfiicant effect on insolvency risk.

96-15: The Suburban Housing Market: Effects of City and Suburban Employment Growth by Richard Voith

Communities in close proximity to areas of growing employment will experience greater upward housing demand shifts from job growth than more distant communities, but the housing market response will depend on the elasticity of supply, which is likely to differ cross communities. Using a data set of over 88,000 housing sales in suburban Philadelphia, the author finds that city employment growth has a significant positive effect on suburban house values; this effect is largest for housing closest to the central business district and declines with distance from the CBD. City employment growth has a negative effect on the rate of suburban house construction; the magnitude of the negative effect increases with distance. Suburban employment growth has little aggregate effect on house prices, and there is less variation in locations near the urban fringe. With regard to the value of real estate assets, city employment growth has a larger average positive effect on total value, including both price and construction impacts. Suburban homeowners and developers may, however, have divergent interests in the spatial pattern of employment growth, since suburban employment growth adds little to the value of homes in older, fully developed communities.

96-16: Risk and Return in the Single-Family Housing Market by Theodore M. Crone and Richard Voith

The tradeoff between risk and return in equity markets is well established. This paper examines the existence of the same tradeoff in the single-family housing market. For home buyers, who constitute about two-thirds of U.S. households, the choice about how much housing and which house to buy is a joint consumption/investment decision. Does this consumption/investment link negate the risk/return tradeoff within the single-family hosuing market? Theory suggests the link still holds. This paper supplies empirical evidence in support of that theoretical result.

96-17: Public Versus Private Debt: Confidentiality, Control, and Product Markets by Mitchell Berlin and Alexander W. Butler

The authors examine a firm's choice between public and private debt in a model where the firm's financing source affects its product market behavior. Two effects are examined. When frims' risk-taking decisions are strategic substitutes, debt financing leads to excessively risky product market strategies (as in Brander and Lewis' (1986) Cournot oligopoly with debt). Lender control through restrictive covenants — which is characteristic of private debt — can commit the firm to reduce aggressiveness in product markets and increase expected profits. This is the monitoring effect. On the other hand, private debt reduces the amount of public information about a firm that becomes available to its competitors. This is the confidentiality effect. When firms' risk-taking decisions are strategic substitutes, firms prefer to precommit to communicate idiosyncratic private information about costs or demand. By choosing public debt, a firm is able to precommit to communicate private information. The choice between public and private debt depends on the relative weights of the monitoring and confidentiality effects.

96-18/R: Deposits and Relationship Lending by Mitchell Berlin and Loretta J. Mester 

The authors empirically examine the hypothesis that access to deposits with inelastic rates (core deposits) permits a bank to make contractual agreements with borrowers that are infeasible if the bank must pay market rates for its funds. Access to core deposits insulates a bank's costs of funds from exogenous shocks, allowing the bank to insulate its borrowers against exogenous credit shocks. Using a large sample of loans from the Survey of the Terms of Bank Lending, the authors find that when they control for competitive conditions in loan markets, banks funded more heavily with core deposits provide more smoothing of loan rates in response to exogenous changes in aggregate credit risk. This suggests that a distinctive feature of bank lending is that firms and banks form multiperiod lending relationships, in which loans need not break even period by period. It also partially explains the declining share of bank loans (or near substitutes for bank loans) in credit markets. As banks have increasingly been forced to pay market rates for an increasing share of their funds, multiperiod relationship lending has become increasingly less feasible and bank loans have lost some of their comparative advantage over securities. The authors' results suggest that access to core deposits is one of the foundations of relationship lending.

96-19: Pricing in Vertically Integrated Network Switches by James J. McAndrews

Many automated teller machine (ATM) networks are partially vertically integrated. A group of downstream retail banks own and operate the upstream network switch. The size of the group varies from network to network. The same situation exists in other network businesses, including airline computer reservation systems and credit card networks. Here the author takes as parametric the size of the group that owns the upstream network, the monopoly structure of the upstream network switch, as well as the size of the downstream industry, all the members of which are connected to the switch. Given these assumptions, the author models the pricing and output behavior of the group of owners as the number of its members varies. The analysis suggests that the more inclusive is the ownership group in a vertically integrated network, the more likely that the network adopts a flat fee (as a function of volume) pricing schedule. Also, the output of the downstream industry initially rises as the ownership group expands, but then contracts as the ownership group includes all of the downstream firms.

96-21: Are There Regimes of Antitrust Enforcement? An Empirical Analysis by Andrew J. Holliday and Gregory P. Hopper

In this paper, the authors propose a new index of antitrust enforcement. The index is compiled from quarterly data from the Department of Justice from 1890 to 1989 and is designed to reflect the relative influence of variables that have deterrent effects. The authors use Hamilton's (1989, 1990) regime-switching technique to estimate a model in which the enforcement index follows a regime-specific AR(1) process. The authors find evidence of long-lived regimes. The high enforcement regime, which lasted from about 1910 to the mid-1960s, produced enforcement that was, on average, almost twice as high as the low enforcement regime. In particular, the Reagan years were not a time of transition to low antitrust enforcement, as is commonly claimed. Rather, the transition to a low enforcement regime had taken place some 15 years earlier.