working 0112 Federal Home Loan Bank Lending to Community Banks: Are Targeted Subsidies Necessary? by Ben R. Craig and James B.

Transcription

1 working p a p e r 0112 Federal Home Loan Bank Lending o Communiy Banks: Are Targeed Subsidies Necessary? by Ben R. Craig and James B. Thomson FEDERAL RESERVE BANK OF CLEVELAND

2 Working papers of he Federal Reserve Bank of Cleveland are preliminary maerials circulaed o simulae discussion and criical commen on research in progress. They may no have been subjec o he formal ediorial review accorded official Federal Reserve Bank of Cleveland publicaions. The views saed herein are hose of he auhors and are no necessarily hose of he Federal Reserve Bank of Cleveland or of he Board of Governors of he Federal Reserve Sysem. Working papers are now available elecronically hrough he Cleveland Fed s sie on he World Wide Web:

3 Working Paper Augus 2001 Federal Home Loan Bank Lending o Communiy Banks: Are Targeed Subsidies Necessary? by Ben R. Craig and James B. Thomson The Gramm-Leach-Bliley Ac of 1999 amended he lending auhoriy of he Federal Home Loan Banks o include advances secured by small enerprise loans of communiy financial insiuions. Three possible reasons for he exension of his selecive credi subsidy o communiy banks and hrifs are examined, including he need o subsidize communiy deposiory insiuions, sabilize he Federal Home Loan Banks, and address a marke failure in rural markes for small enerprise loans. We empirically invesigae wheher funding consrains impac he small-business lending decision by rural communiy banks. Specifically, we esimae wo empirical models of small-business lending by communiy banks. The daa rejec he hypohesis ha access o increased funds will increase he amoun of small-business loans made by communiy banks. JEL Codes: G2 Key Words: small business loans, communiy banks, governmen sponsored enerprises Ben R. Craig and James Thomson are a he Federal Reserve Bank of Cleveland. Correspondence concerning his paper should be direced o James Thomson a jb.homson@clev.frb.org or (216) This work was compleed while Ben Craig was a visiing scholar a he Bundesbank. The auhors hank Ed Kane, John Thornon, Walker Todd, and Ber Ely for commens and suggesions, and Pa Higgins and Korhan Bilek for ousanding research suppor.

4 Federal Home Loan Bank Lending o Communiy Banks: Are Targeed Subsidies Necessary? The Financial Services Modernizaion Ac of 1999 brough abou sweeping changes o he financial sysem. 1 Also known as he Gramm-Leach-Bliley Ac (GBLA), his saue represens he single mos imporan se of regulaory reforms since he Glass-Seagall Ac of The GBLA repeals many of he provisions of he Glass-Seagall and Bank Holding Company Acs ha prohibi or limi he affiliaion of banks wih oher nondeposiory financial firms. Ironically, while he spiri of GBLA is consisen wih effors o reduce financial-marke disorions caused by governmen inervenion, he legislaion inroduces a new disorion ino financial markes by permiing Federal Home Loan Banks o lend o communiy financial insiuions. 2 Tile VI, Secion 604, of he GBLA amends he Federal Home Loan Bank Ac o exend he lending auhoriy of he Federal Home Loan Banks (FHLBs). The amendmen allows he FHLBs o make advances secured by he small business and small agriculural loans of communiy financial insiuions. This new FHLB lending power means ha communiy banks and hrifs can now fund loans o small businesses and agriculural concerns wih somehing oher han deposis. By providing communiy financial insiuions wih a subsidized source of funds, Congress sough o encourage increased lending o small enerprises. Unforunaely, selecive credi subsidies have proven o be inefficien ools for promoing a financial aciviy, such as small business lending, or a paricular se of firms such as communiy financial insiuions. Moreover, here is a wide lieraure (see for example, Kane [1970, 1977]) ha shows how his ype of governmen inervenion disors privae incenives. These disorions in incenives resul in uninended effecs of he policy ha reduce he effeciveness of he inervenion even make i counerproducive while increasing is cos. The GLBA exension of FHLB lending powers is likely o increase axpayer exposure o bank losses, misallocae funds ha may be more efficienly used elsewhere and unnecessarily ransfer wealh from deposiors and axpayers o he owners of communiy financial insiuions, FHLBs, 1 Public Law Secion 602 of he GLBA amended secion 2 of he Federal Home Loan Bank Ac, defining a communiy financial insiuion as follows: The erm communiy financial insiuion means ha he financial insiuions has deposis insured under he Federal Deposi Insurance Ac and has, as of he dae of he ransacion a issue, less han $500,000,000 in average oal asses, based on an average of oal asses over he 3 years preceding ha dae. Ibid, foonoe 1. 1

5 and small enerprises. If his wealh ransfer is ruly he purpose of he ac hen classic economic welfare argumens sugges a more efficien direc cash subsidy. In his paper we examine wheher we need o subsidize he funding of he small enerprise loan porfolios of communiy financial insiuions. We speculae ha in exending he FHLBs lending auhoriy, Congress inended o address one of hree possible problems. Then, we invesigae wheher hese problems are real or no. Secion I describes he possible scenarios. Congress may have hough ha he FHLBs needed a new role in financial markes o ensure heir survival. Perhaps hey perceive ha communiy financial insiuions need subsidies o say afloa. A hird possibiliy is ha legislaors may have believed ha small business and agriculural lending in rural areas would suffer wihou Congressional suppor. We presen evidence agains he use of selecive credi subsidies o ensure he viabiliy of he FHLBs or communiy banks. We argue ha even if hese perceived needs are real, here are alernaive policies for addressing hem ha dominae his form of inervenion. The remainder of our analysis focuses on refuing he hypohesis ha communiy financial insiuions need more funds o increase heir rural small business lending. Specifically, we empirically invesigae wheher funding consrains affec he lending decision a communiy banks. In secion II, we describe our daa, including summary saisics, and ouline our empirical sraegy. The empirical resuls are presened in secion III. Overall, he empirical evidence demonsraes ha funding does no consrain rural small business lending, so he FHLB lending provisions of he Ac will have no beneficial effec on such lending. Conclusions and policy implicaions are in secion IV. I. Wha Was Congress Thinking? The exisence of financial inermediaries ells us ha he perfec capial marke assumpions ha underpin he Modigliani-Miller irrelevance of he form of capial does no hold. For policymakers, he quesion is no wheher financial markes (money, capial, and paymens markes) are fricionless. Raher, he quesion is, do he privae secor insiuions ha arise o miigae (or arbirage away) marke fricions serve o complee he markes? If no, hen public inervenion in markes may be required. In his case, we are ineresed in he objecives underlying he use of an exising governmen-sponsored enerprise (GSE) o subsidize he funding of communiy financial insiuion s small business loans. Moreover, we are ineresed in wheher or no exending FHLB lending auhoriy is he mos effecive inervenion for achieving hese objecives. 2

6 One possible moivaion for he GBLA small business lending provisions is he desire of Congress o subsidize he aciviies of communiy financial insiuions. Subsidizaion of hese asse-challenged deposiory insiuions migh be warraned if he social benefis associaed wih heir operaion exceeded he privae benefis. However, for our purposes he poin is no wheher subsidies o communiy financial insiuions are necessary, bu raher given if Congress has decided o subsidize hese deposiories, is he mehod underaken in GBLA he bes one from he sandpoin of social welfare? By allowing communiy financial insiuions o pledge small enerprise loans as collaeral for FHLB advances, he GBLA is engaging in selecive credi allocaion. From Kane (1977), we know ha selecive credi allocaion is an inefficien and ofen counerproducive policy ool. In he case of communiy financial insiuions, he provision of subsidies ied o small enerprise lending is likely o have cosly uninended effecs. For one, if communiy financial insiuions are no funding-consrained hen his subsidy ied o small-enerprise lending is no likely o increase he amoun of credi exended. However, he abiliy o subsiue FHLB advances for deposis o fund exising small-enerprise loans increases he deposi-marke power of communiy banks and hrifs o he derimen of deposiors, in paricular small savers. To he exen ha access o addiional funds hrough he FHLB simulaes addiional lending by communiy deposiories, he new credis are likely o carry higher defaul risk han hose already in he porfolio. Moreover, given he limied geographic scope of communiy banks and hrifs hese new credis are likely o be highly correlaed wih he insiuion s exising loan porfolio. 3 In oher words, a he macroeconomic level, his form of selecive credi allocaion may resul in an overinvesmen in risky asses in he economy, and a he insiuion-level, increases he probabiliy of failure and expeced losses o uninsured claimans and he Federal Deposi Insurance Corporaion. Indeed, if Congress wans o ensure he viabiliy of communiy financial insiuions, here are more economically efficien mehods for doing his. For example, he Congress could exend o all communiy financial insiuions he ax-benefis associaed wih being organized as a subchaper S corporaion. 4 Moreover, Congress could reduce he regulaory burden of hese communiy deposiories by exemping hem from he Communiy Reinvesmen Ac and oher consumer regulaions where he fixed coss of compliance, such as reporing requiremens, are high. 3 See Flannery (1989) for an alernaive explanaion. 3

7 A second raionale for he GLBA amendmens o FHLB lending auhoriy is a desire o ensure he coninued viabiliy of he Federal Home Loan Banks by providing hem wih an addiional role in financial markes. The FHLBs were originally par of an insiuional srucure se up o promoe housing finance, which included a separaely charered se of deposiory insiuions and savings associaions, as lenders. 5 Like all governmen-sponsored enerprises (GSEs), he FHLBs represen an indirec governmen inervenion, in par because he charering of a GSE o carry ou a paricular public mission requires an ac of Congress. Why should Congress be concerned abou he survival of a GSE? Afer all, he jusificaion for charering a GSE is o perform a needed marke-compleion service no being provided by privae inermediaries. The fac ha a GSE is no longer viable may indicae ha i is no longer needed o carry ou ha funcion, or i may be a signal ha flaws in is design keep i from performing he needed role. In he firs case, markes may have developed o he degree ha coninued governmen inervenion is no longer needed. In he second case, governmen inervenion is sill required, bu he exising mehod of inervenion needs o be replaced wih one ha performs he needed funcion. In eiher of hese wo cases, social welfare would be enhanced by he orderly exi of his governmen-subsidized compeior from financial markes. If indeed he exisence of he FHLBs is in quesion, i is because of dramaic changes in financial markes since he 1930s. In paricular, he increased efficiency of housing-finance markes in he Unied Saes has reduced (if no eliminaed) he need for direc and indirec governmen inervenion o suppor his marke, including he radiional funcions performed by he FHLBs. 6 Given he lessons of he hrif debacle, i is no surprising ha Congress would be concerned when he survival of one of hese financial insiuions comes ino quesion. The cos 4 See Harvey and Padge (2000). 5 Two pieces of legislaion, he Home Loan Bank Ac of 1932 and he Naional Housing Ac of 1934, esablished he foundaion of federal policy for housing finance and he infrasrucure for promoing and regulaing he housing finance indusry he Federal Home Loan Bank Sysem. A incepion, he Federal Home Loan Bank Sysem consised of 12 Banks (similar in charer and organizaion o he 12 Federal Reserve Banks), he Federal Savings and Loan Insurance Corporaion (similar o he FDIC), he Home Owners Loan Corporaion, he Federal Home Loan Bank Board (analogous o he Federal Reserve Board) o oversee he Sysem, and charer federal savings and loans (equivalen o he Office of he Comproller of he Currency). The Federal Home Loan Bank Board and is successor he Federal Housing Finance Board would include all Federal Home Loan Bank member insiuions in he definiion of he Federal Home Loan Bank Sysem. For a conemporary discussion of he Federal Home Loan Bank Sysem and is mandae o promoe housing, see McDonough (1934). 6 Laderman and Passmore (2000) raise quesions as o he need a separae hrif charer o promoe housing finance. Moreover, recen research by Heuson, Passmore and Sparks (2000) calls ino quesion wheher morgage securiizaion done large by GSEs has resuled in lower morgage raes. These auhors find ha he causaion runs from lower morgage raes o securiizaion and no he oher way around 4

8 associaed wih deviaions of GSEs from heir original mission is a major policy concern. Afer all he goals of GSEs, such as he FHL Banks, are muddled when he ineress of heir shareholders are no closely aligned wih he mission associaed wih he enerprises public charer. To he exen ha public and privae ineress diverge, GSEs are prone o mission creep a suble shif away from heir original mandae. Mission creep can lead o undesirable disorions in financial markes, including resource misallocaions and increased axpayer exposure poenial losses associaed wih he aciviies of hese GSEs. Unchecked by welldefined legislaive limis on GSE aciviies, mission creep coupled wih compeiive advanages associaed wih heirpublic charer could enable hese firms o dominae heir markes a he expense of heir privae compeiors. 7 One lesson from he 1980s hrif debacle is ha he moral-hazard problems associaed wih governmen-subsidized funding of a financial insiuion increase dramaically as i comes under financial disress. 8 In he case of a GSE, imely acion by he Congress may be needed o conain he poenial losses o axpayers and he deadweigh losses o he economy associaed wih he gambling for resurrecion sraegies ha ensue. There are, however, wo alernaives o expanding he FHLBs franchise ha would have addressed concerns Congress may have had abou he increasing moral hazard incenives faced by he FHLB s. The firs alernaive would be legislaion ha mandaed an orderly wihdrawal of he FHLBs from markes and liquidaion of heir remaining asses. A second alernaive would be a full privaizaion of he FHLBs. Privaizaion would include an explici wihdrawal of governmen subsidies o he Federal Home Loan Banks and he phasing ou of resricions on heir aciviies. 9 I is noable ha privaizaion was he roue aken by Sallie Mae. 10 Boh of hese alernaives would reduce he disorions associaed wih governmen inervenion in markes, while he laer would allow for a role for he FHLBs in hose financial markes in which hey are compeiive. 7 For example, as Maloney and Thomson (2001) poin ou, i is difficul o reconcile he FHLBs large invesmen in morgage-backed securiies issued by oher GSEs wih he FHLBs mission. In effec, he leveraging of he implici governmen guaranees of he FHLBs consolidaed obligaion bonds bonds issued on behalf of he 12 FHL Banks collecively o inves in markeable securiies is analogous o he FHLBs operaing a governmen subsidized hedge fund. 8 See Kane (1989). 9. The idea ha a GSE should be privaized once is mission has been achieved is no new. As former Depuy Assisan Secreary of he Treasury Darcey Bradbury (1995) noes, The Treasury has for a number of years, in Democraic and Republican Adminisraions, believed ha i is appropriae o wean a GSE from Federal sponsorship once he GSE becomes economically viable and successfully fulfills he purpose for which i was creaed wih Federal sponsorship, or when he purpose for which i was creaed ceases o exis. 10 See he Suden Loan Markeing Associaion (1996). 5

9 Ensuring ha adequae funds are available o small businesses and family farms represens a hird possible raionale for he GLBA exension of he FHLBs lending auhoriy (o include advances secured by he small enerprise loans of communiy banks and hrifs). Why would Congress exend anoher subsidy o suppor lending o secors of he economy for which here is already a liany of programs such as he Small Business Adminisraion s loan guaranee program for small business loans and he Farm Credi Banks in agriculure designed o do ha? One possible answer lies in work by Peerson and Rajan (1994) and Berger and Udell (1995) on he imporance of banking relaionships in he small business loan marke. 11 This work suggess ha exising programs o suppor lending o small enerprises, and in paricular small businesses, rely heavily on he abiliy of communiy banks o fund new loans. This would be especially rue in rural markes where communiy banks are likely o be he main source of credi. Therefore, if communiy banks are funding-consrained hen a number of profiable loans would no be funded, irrespecive of exising loan-guaranee programs. In his case, governmen inervenion, such as he GLBA amendmens o FHLB lending auhoriy, migh be jusified because of he deadweigh losses associaed wih no funding all posiive-ne-presen-value projecs in he economy. To he exen ha communiy banks are no funding-consrained, his new source of funding ied o small enerprise loans is no likely o increase funds available o small businesses. In his case, FHLB advances secured by small business and small agriculural credis will be used o replace deposis, increasing whaever marke power communiy banks in non-urban markes have. Neumark and Sharp (1992) documen an asymmeric response of consumer deposi raes o changes in marke ineres raes deposi raes follow marke raes up wih a lag, bu closely follow marke raes down. Hence, an uninended consequence of he Ac s FHLB lending provisions could be a wealh ransfer from small savers o he owners of communiy banks and hrifs. Wheher FHLB advances are likely o lead o increased small business lending by communiy financial insiuions or will be used for oher purposes such as deposi replacemen or for alernaive funding opporuniies is an empirical issue, which we address in his paper. To do his we focus on he small-business lending aciviies of communiy banks, paricularly hose headquarered in non-msa counies, and es he following hypohesis: 11 Kane and Malkiel (1965) provide an early analysis of he imporance of relaionships in business lending. 6

10 H 0 : Increasing communiy-bank access o funds will significanly increase heir smallbusiness lending. II. The Sample and Empirical Mehod The sample consiss of balance-shee and income-saemen daa for FDIC-insured banks from 1993 hrough 1999 from he June Federal Financial Insiuion Repors of Income and Condiion (call repors). The sample is limied o he June call repors because ha is he only quarer small business loan daa is repored, saring June In addiion, we colleced daa from he FDIC s annual Summary of Deposi Daa filed each June. Finally, we include economic-condiions daa from he Bureau of Labor Saisics and he Bureau of Economic Analysis. These daa were aggregaed from couny and MSA saisics on unemploymen raes, populaion and income colleced for each calendar year. In his paper, he analysis concenraes on small business lending by communiy banks for wo reasons. Firs, focusing on small business loans capures he credi secor ha he ac is inended o subsidize more exacly. 12 Second, commercial lending by hrif insiuions is consrained by oher limis legislaed by Congress. 13 To es our null hypohesis we consruc a regression sysem of equaions where deposis and small-business loans are assumed o be endogenous. If he effec of deposis (once he endogeneiy of he variable is aken ino accoun) on small-business loans is posiive, hen his would indicae ha he banks are funding consrained and would suppor he hypohesis, H o. A firs se of equaions relaes he porfolio share of small-business loans o proxy variables from he balance shee designed o capure sources of funds for small-business loans and compeing uses, as well as variables o conrol for marke srucure and various fixed effecs relaed o economic condiions in he bank s marke. The model is: DEPA = β n m p 0 + β j BS j, + β jms j, + β j j= 1 j= n+ 1 j= m+ 1 EC j, + ε (1) l SBLA = + λ DEPA + λ BS + λ MS + λ EC + µ, α 0 1 j j, j j, j j, j= 2 j= l+ 1 j= k+ 1 k h (2) 12 We also limi he sample o small business loans because of concerns abou he qualiy of he small agriculural loan daa on he call repors. In addiion, preliminary work using he small agriculural loan daa calls ino quesion wheher i is appropriae o pool hese credis wih he small business loans. 13 The acs include he Garn-S Germain Ac of 1982, and he qualified hrif lender es in he Compeiive Equaliy Banking Ac of 1987 as amended by he Economic Growh and Regulaory Paperwork Reducion 7

11 where, DEPA and SBLA are he deposis o asses and small-business-loans o asses raios, respecively, BS j is he j h variable consruced from balance shee daa, MS j is he j h marke srucure proxy, and EC j is he j h economic condiions variable included o conrol for he economic environmen. Four balance-shee variables are included in equaion (1). The naural log of oal asses scaled by oal asses is included as a regressor o conrol for he correlaion beween he size of a bank and is reliance on deposis. 14 We include he capial-o-asse raio because i represens an alernaive funding source and o conrol for he possible influence of capial regulaion. Federal funds purchased o asses and oher borrowed money o asses are included in he deposi equaion because hey represen alernaive funding sources, ones ha a he margin migh be less expensive han raising addiional deposis. To conrol for he impac of marke srucure we include he bank s marke share of deposis in is home marke, a dummy variable equal o one if he bank is headquarered in a rural couny, and he oal number of branches. Finally, for a bank s primary marke we include he unemploymen rae, populaion growh, and he naural log of per capia income o conrol for he economic environmen. The primary regressor of ineres in (2) is he endogenous deposi-o-asse raio. For he null hypohesis, H 0, ha he communiy-bank lending marke is consrained by a lack of funds, o hold, he esimaed coefficien on his variable, λ 1, needs o be posiive and significan. However, we include a number of oher balance-shee proxy variables o capure he effecs of oher bank asse and liabiliy decisions ha impac he size of he small business loan porfolio. As in equaion (1), we include he naural-log-of-asses-o- asses raio and he capial-o-asses raio o conrol for he impac of size and capial on small-business lending. We also include hree variables, which represen compeing uses of funds: large business loans o asses, securiies o asses, and federal funds sold o asses. To conrol for marke srucure we include he number of branches, a non-msa dummy (equal o one if he bank is headquarered in a non-msa couny) and he deposi Herfindahl index for he marke where he bank is headquarered. Finally, he lending opporuniy faced by he bank is conrolled for he inclusion of he same economics condiions variables as equaion (1). Some care needs o be exercised in inerpreing coefficiens in saic porfolio-share regressions. Equaions (1) and (2) provide us wih an undersanding of how funding and oher asse decisions, given marke srucure and economic condiions, deermine he share of asses Ac of The 1996 legislaion complicaes he analysis of he deerminans of hrif-small business lending by allowing such credis o be couned wihou limi owards meeing he qualified hrif lender es. 8

12 invesed in small-business loans. While his framework provides us wih insigh as o he imporance of funding consrains, i does no allow us o es direcly wheher addiional smallbusiness lending is condiioned by he abiliy of he bank o raise addiional funds. To do his we propose a second sysem of equaions ha looks a he year-o-year change in deposis and small business loans. LNDEP = β n m p 0 + β j LNBS j, + β jms j, + β j j= 1 j= n+ 1 j= m+ 1 EC j, + ε (3) l α LNSBL = + λ LNDEP + λ LNBS + λ MS + λ EC + µ 0 1 j j, j j, 1 j j, 1 j = 2 j = l + 1 j = k + 1 k h (4) Equaions (3) and (4) are essenially our firs sysem wih he porfolio-share variables replaced by logarihmic changes in he underlying asse or liabiliy caegory. Thus LNSBL, LNDEP, and LNBS j s represen changes in he naural logarihm of levels of small-business loans, deposis and balance-shee variables from ime -1 o. 15 In addiion, he marke-srucure variables are lagged one period o conrol for he effec of exising economic srucure on hese changes in he deposis and small business loans. The lis of he variables in equaions (3) and (4) along wih heir definiions is presened in able 1. As before, he focus of hese regressions is on he small-business lending equaion, and he deposi equaion and small-business lending equaions are joinly esimaed in a sysem where he change in deposis and change in small business loans are assumed endogenous. If he null hypohesis of communiy-bank smallbusiness lending being funding-consrained is rue, we expec he esimaed coefficien on he change in deposis, λ 1, o be posiive and significan. III. The Empirical Resuls Sysem in Levels Our firs sysem in levels represened by equaions (1) and (2) are esimaed over he enire sample of banks and six subsamples: all banks in Meropolian Saisical Areas (MSAs), 14 Oher specificaions for his size proxy were used such as he naural log of oal asses (unscaled). Our resuls were no sensiive o he specificaion of his variable. 15 To preserve observaions wih a value of zero we add one o all observaions prior o aking he naural logarihm. 9

13 all banks in non-msas, communiy banks in MSAs, communiy banks in non-msas, large banks in MSAs, and large banks in non-msas. 16 Given ha we are ineresed in he GBLA provision ha allows FHLBs o lend agains he small-business loan porfolios communiy banks, we focus our discussion on he communiy-bank regressions, especially for he non-msa sample. 17 Table 2 presens he resuls for equaions (1) and (2) over he sample of direcly impaced by he new FHLB lending auhoriy banks wih asses less han $500 million. Table 2 repors he resuls for he model esimaed over he MSA communiy bank (under $500 million in asses) and non-msa couny communiy bank samples. We repor he resuls for he all banks under $500 million in asses sample because, for equaion 2, he daa rejec he pooling of he banks in non-msas under $500 million in asses wih banks in MSAs under $500 million in asses a he 1 percen level. 18 The op panel in able 2 presens he resuls for equaion (1). As expeced, he coefficiens of he capial asse raio, he federal-funds-purchased raio and he oher-borrowedmoney raio are negaive and significan, indicaing ha reliance on deposis as a source of funds is inversely relaed o he use of oher funding sources. However, for communiy banks, wheher MSA or rural, he main alernaive o deposi funding appears o be capial. The significanly posiive coefficien on he naural-log-of-oal-asses-o-oal-asses raio suggess ha for communiy banks, size has a significanly negaive impac on he proporion of asses funded by deposis. As expeced, he effec of he number of bank branches is posiively and significanly relaed o he reliance of communiy banks on deposis o fund asses. The reliance of ciy communiy banks on deposi funding is significanly posiively relaed o heir share of deposis in heir home marke. This is in conras o an insignifican effec of he marke share on deposis for non-msa communiy banks. Finally, he significance of he economics condiions variables in all he subsamples illusraes he imporance of conrolling for hese effecs in his regression sysem. The resuls for equaion (2) are presened in he lower panel of able 2. Under he null hypohesis, he coefficien on he deposis-o-asses raio is expeced o be posiive and 16 All equaions are esimaed using SAS version We also esimaed a version of he model where small business loans o asses is replaced by oal loans o asses as he dependen variable in equaion (2) and dropping he LBLOANA variable as a regressor. 18 The communiy banks in rural areas sample conforms mos closely under he null hypohesis o hose banks ha he GBLA is argeing. Therefore, we also es for differences across our sample of rural banks. For equaion 2 he daa rejec he pooling of he non-msa communiy bank sample wih he sample of banks in non-msas wih asses greaer han $500 million a he 1 percen level. 10

14 significan. We find a posiive and significan relaionship beween small business loans, as a share of asses, and deposis o asses in he MSA banks less han $500 million sample. However, for he rural communiy bank sample he coefficien on he deposi variable is negaive and significan. This resul for rural communiy banks is no consisen wih a null hypohesis of a communiy-bank lending marke ha is consrained by a lack of deposis. No surprisingly, he daa rejec he equaliy of he coefficiens on he deposi-o-asse raios across he MSA and non- MSA communiy bank samples. The negaive and significan coefficien on he capial-o-asses raio for non-msa banks in able 2 suggess ha rules limiing he percenage of capial a bank can be exposed o any single borrower may be binding for rural communiy banks. In oher words, banks wih higher capial-per-dollar-of-asses are able o make larger loans o profiable cusomers and hence, fewer loans ha would be classified as small business loans. Alernaive lending and invesmen opporuniies large business loans o asses, securiies o asses, and federal funds sold o asses capure he effec of oher uses of funds on he small-business-loan porfolio. All hree of our proxies for oher uses of funds are negaive and significan, as expeced. I is ineresing o noe ha he esimaed coefficiens for he non- MSA communiy-bank subsample are significanly smaller han for he MSA communiy-bank subsample. The smaller effec of he alernaive lending and invesmen opporuniies on he small-business-loans-o-asses raio for rural communiy banks is consisen wih hese banks having fewer available profiable lending opporuniies. This resul is also no consisen wih he null hypohesis. The coefficien on he naural-log-of-asses-o-asses raio is negaive and significan in boh samples. Noe, scaling he naural of asses by oal asses makes his regressor inversely relaed o size and hence, larger communiy banks have a higher percenage of asses in loans including small-business loans, alhough he effec of size on small business lending is significanly higher for urban communiy banks han rural ones presumably reflecing a beer lending environmen for urban banks. For rural communiy banks an increase in he number of branches significanly increases he share small business loans in he porfolio. Somewha surprising, however, is he negaive and significan coefficien on he number of branches for urban communiy banks. To he exen ha small-business lending is relaionship lending han we would expec a posiive relaionship beween he number of branches and he proporion of small business loans held by a bank. 11

15 Marke concenraion, as capured by he deposi Herfindahl, is negaively relaed o SBLA for boh MSA banks and non-msa banks, bu i is no significan in he non-msa sample. For urban communiy banks a higher Herfindahl index in heir home marke is likely due o dominance of ha marke by large banks and hence, he negaive coefficien on HERF suggess fewer profiable lending opporuniies for communiy banks in concenraed urban markes. The MSA resuls are consisen wih Boo and Thakor s (2000) finding ha inerbank compeiion increases he amoun of relaionship lending by banks. Overall, he resuls of he firs sage model are more consisen wih he alernaive hypohesis han hey are wih he hypohesis ha communiy banks small business loans are consrained by heir funds. For communiy banks in non-msa counies we fail o find a significan relaionship beween small business loans and deposis. Moreover, he behavior of he proxies for compeing uses of funds is more consisen wih a hypohesis ha he lack of good lending opporuniies consrains small business lending han wih he presence of funding consrains. Thus he communiy banks are consrained more by he demand side of he marke for loans, and no by he supply of funds. Hence, hese resuls suppor he presence of alernaive uses of funds and rejec he consrained funds explanaion for lower levels of small business loans. Sysem in Raes of Change The resuls for deposis and lending in levels, equaions (1) and (2), provide us wih he empirical relaionship beween he share of asses funded wih deposis and he level of invesmen in (porfolio share of) small business loans. This, however, is a saic view of he lending process and an indirec es of he funding consrain hypohesis. A more direc es of he null hypohesis is o look a he change in small business lending over ime as i relaes o changes in oher balance shee variables. To his end we esimae he same equaions in raes of change (our equaions (3) and (4) above) over he same sample breakdowns as before. As wih our firs sysem of equaions, for he small business lending equaion (equaion 4) he daa rejec pooling he non-msa communiy bank sample wih he MSA communiy bank sample. 19 The op panel in able 3 presens he resuls for he change in deposi regressions. As expeced, he signs on he alernaive funding sources variables change in capial, change in federal funds purchased and change in oher borrowed money are negaive and significan for 19 For equaion 4 he daa also rejec he pooling of he non-msa communiy bank sample wih he non- MSA large bank sample. 12

16 boh samples. Moreover, he effec of asse growh on deposis as is posiive and significan for his group of banks. On he oher hand, he negaive and significan coefficien on deposi marke share a -1 for rural communiy banks conforms o our expecaion ha banks wih a high deposi marke shares will have difficuly increasing heir deposis a or above he rae of deposi growh in he marke. The insignifican coefficien on deposi marke share for ciy communiy banks is consisen wih his explanaion. The lower panel of able 3 presens he resuls for equaion (4). From able 3 we see ha he coefficiens on change in deposis and change in capial are no significanly differen from zero for he MSA Banks and he Non MSA Banks regressions. For boh samples, he change in he oher uses of funds variables change in large business loans, change in securiies, and change in federal funds sold are significanly negaively relaed o he change in small business loans. The magniude of hese effecs is significanly larger for he rural communiy banks han for hose headquarered in MSAs. Especially noeworhy is he coefficien on change in securiies, which is nearly four imes larger in absolue value for he non-msa communiy banks han for heir urban counerpars. The mos likely explanaion for his resul is a lack of profiable small business lending opporuniies in heir home markes. In oher words, communiy banks rely on asse managemen o accommodae changes in loan demand, and in his case he demand for small business loans. The absence of any effecs of funding on he change in small business loans and evidence ha loan demand is accommodaed hrough pure asse managemen is srong evidence agains our null hypohesis. Finally, he change in small business loans is significanly posiively relaed o asse growh and he number of branches a -1 for MSA and non-msa communiy banks, and is significanly negaively relaed o he deposi marke Herfindahl a -1 for rural communiy banks. The posiive and significan coefficien on he change in asses for boh MSA and non- MSA communiy banks suggess ha for banks ha are growing, he rae of growh in he small business loan porfolios exceeds asse growh. In addiion, he posiive coefficien on he number of branches a -1 poins o he imporance of branches as a real opion o develop he relaionships needed o profiably engage in small business lending. To he exen ha a deposi marke concenraion measure capures he compeiiveness of he marke, he insignifican coefficien on he deposi marke Herfindahl a -1 for urban communiy banks and he significanly negaive coefficien on his Herfindahl index for rural communiy banks suggess ha monopoly power reduces he change in small business loans. Finally, he performance of he 13

17 economic condiions proxies is consisen wih he need o conrol for fixed effecs in hese regressions. Overall, he resuls of our empirical ess find lile evidence o supporing he null hypohesis. Our models of small business lending fail o find a significan relaionship beween deposis and small business loans in boh he share/level regressions and he change regressions. Moreover, we find evidence of asse managemen by communiy banks, especially hose headquarered in non-msa counies, o accommodae changes in loan demand. IV. Conclusion and Policy Implicaions The enhancemen of FHLB lending auhoriy o include small enerprise loans by communiy financial insiuions appears o have lile economic jusificaion. Three possible raionales for Congress including his FHLB reform in GBLA are oulined and invesigaed including: he desire o subsidize communiy banks, he need o miigae moral hazard incenives associaed wih an increasingly nonviable GSE, and he need o correc a marke failure in he small business lending markes. We argue ha he firs wo possible objecives could be addressed hrough measures ha are less disorionary and hence less cosly o sociey. We formally es he hird possible objecive. Our empirical analysis of he small business lending aciviies of communiy banks fails o find any evidence of funding consrains he presumed source of marke failure. The resuls, however, are consisen wih communiy banks in non-msa counies having more funds available han hey can profiably lend. In fac, we find srong evidence ha hese banks uilize pure asse managemen o accommodae changes in loan demand. Therefore, i is unlikely ha he GBLA s exension of FHLB lending auhoriy o include advances secured by he small enerprise porfolios of communiy banks and hrifs will maerially increase small enerprise lending. This new selecive credi allocaion scheme is likely o have coss, however. Sojanovic e al. (2000) show how FHLB advances could lead o increased risk-aking by communiy financial insiuions and hence, increased loss exposure o he Federal Deposi Insurance Corporaion. Maloney and Thomson (2001) poin ou he implicaions of exending FHLB lending auhoriy for he riskiness of he FHLBs and he consequen increased risk o axpayers. In addiion, o he exen ha hese advances are used by communiy financial insiuions for deposi replacemen, he effec of his selecive credi allocaion scheme will be o subsidize 14

18 communiy banks a he expense of deposiors This is eerily reminiscen of he policies adoped in he 1960s o sabilize he hrif indusry. See Kane (1970). 15

19 References Berger, A. N., and G. F. Udell, 1998, The Economics of Small Business Finance: The Roles of Privae Equiy and Deb Markes in he Financial Growh Cycle, Journal of Banking and Finance 22:6-8, Berger, A. N., and G. F. Udell, 1995, Relaionship Lending and Lines of Credi in Small Firm Finance, Journal of Business 68:3 (July), Boo, A. W. A, and A. V. Thakor, 2000, Can Relaionship Banking Survive Compeiion? Journal of Finance, 55:2 (April), Bradbury,Darcy, 1995, Depuy Assisan Secreary of he Treasury for Federal Finance, Saemen before he Subcommiee on Educaion, Ars, and Humaniies of he Senae Commiee on Labor and Human Resources (June 20). Congressional Budge Office, Assessing he Public Coss and Benefis of Fannie Mae and Freddie Mac, Washingon, DC: Governmen Prining Office, Feldman, R., 1998, Esimaing and Managing he Federal Subsidy of Fannie Mae and Freddie Mac: Is Eiher Task Possible, Journal of Pubic Budgeing, Accouning, and Financial Managemen, Flannery, Mark J., 1989, Capial Regulaion and Insured Banks Choice of Individual Loan Defaul Risk, Journal of Moneary Economics (Sepember), Harvey, J., and J. Padge, 2000, Subchaper S A New Tool for Enhancing he Value of Communiy Banks, Financial Indusry Perspecives (December), Federal Reserve Bank of Kansas Ciy, Heuson, A., W. Passmore, and R. Sparks, 2000, Credi Scoring and Morgage Securiizaion: Do They Lower Morgage Raes? Finance and Economics Discussion Series , Federal Reserve Board, Washingon, DC. Kane, E. J., 1999, Housing Finance GSEs: Who Ges he Subsidy? Journal of Financial Services Research 15:3, Kane, E. J., 1989, The S&L Insurance Mess: How Did i Happen? Washingon, D.C.: The Urban Insiue Press. Kane, E. J., 1977, Good Inenions and Uninended Evil: The Case agains Selecive Credi Allocaion, Journal of Money, Credi and Banking 9:1 (February, par 1), Kane, E. J., 1970, Shor-Changing he Small Saver: Federal Governmen Discriminaion agains he Small Saver During he Vienam War, Journal of Money, Credi, and Banking 2:4 (November), Kane, E. J., and B. G. Malkiel, 1965, Bank Porfolio Allocaion, Deposi Variabiliy, and he Availabiliy Docrine, Quarerly Journal of Economics 89 (February),

20 Laderman, Elizabeh, and Wayne Passmore, 2000, Do Savings Associaions Have a Special Commimen o Housing? Journal of Financial Services Research 17:1 (February), Maddala, G. S., 1986, Economeric Issues in he Empirical Analysis of Thrif Insiuions Insolvency and Failure, Federal Home Loan Bank Board Working Paper (Ocober). Maloney, D. K., and J. B. Thomson, 2001, The Changing Role of he Federal Home Loan Banks, Federal Reserve Bank of Cleveland, Economic Commenary, forhcoming. McDonough, J. E., 1934, The Federal Home Loan Bank Sysem, American Economic Review 24:4 (December), Neumark, D., and S. A. Sharpe, 1992, Marke Srucure and he Naure of Price Rigidiy: Evidence from he Marke for Consumer Deposis, Quarerly Journal of Economics 107:2 (May 1992), Oserberg, W. P., and J. B. Thomson, 1999, Banking Consolidaion and Corresponden Banking, Federal Reserve Bank of Cleveland, Economic Review (1s Quarer), Peersen, M. A. and R. G. Rajan, 1994, The Benefis of Lending Relaionships: Evidence from Small Business Daa, Journal of Finance 49:1 (March), Suden Loan Markeing Associaion, A Guide o he Suden Loan Markeing Associaion Reorganizaion Ac of 1996 (Ocober), Washingon, DC. Smih, Rixey, and Norman Beasley, 1939, Carer Glass: A Biography, New York, NY: Longmans, Green and Co. Sojanovic, D., M. D. Vaughn, and T. J. Yeager, 2000, Is Federal Home Loan Bank Funding A Risky Business For The FDIC? The Regional Economis (Ocober), Federal Reserve Bank Of S. Louis,

21 TABLE 1: Variable Definiions Variable Type Definiion Source Capial o asses BS Capial o asse raio June Call Repor Deposis o asses BS Deposis o asse raio June Call Repor Fed Funds purchased o asses BS Federal funds purchased and securiies sold under agreemens o repurchase o asses raio June Call Repor Fed Funds sold o asses BS Federal funds sold and securiies purchased under agreemens o resell o asses raio June Call Repor Large business loans o asses BS (Commercial and indusrial loans + commercial real esae loans - small business loans)/asses June Call Repor Naural log of asses o asses BS Naural Log of oal asses o oal asses June Call Repor Oher borrowed money o asses BS Oher borrowed money o asses raio June Call Repor Securiies o asses BS Small business loans o asses raio June Call Repor Small business loans o asses BS Securiies o asses raio June Call Repor Number of branches MS Toal number of branches Summary of Deposis Deposi Herfindahl MS Deposi marke Herfindahl in he bank's home marke (non-msa couny or he MSA ) Summary of Deposis Deposi marke share MS Deposi marke share of he bank in is home marke (non-msa couny or MSA) Summary of Deposis Naural log of per capia income EC Naural Log of per capia income in he bank's home marke (non-msa couny or he MSA ) Bureau of Economic Analysis Populaion growh rae EC Annual populaion growh in he bank's home marke (non-msa couny or he MSA ) Bureau of Economic Analysis Unemploymen rae EC The unemploymen rae in he bank's home marke (non-msa couny or he MSA ) Bureau of Labor Saisics LN in Asses BS Naural log of asses a minus he naural log of asses a -1 June Call Repor LN in Capial BS Naural log of capial a minus he naural log of capial a -1 June Call Repor LN in Deposis BS Naural log of deposis a minus he naural log of deposis a -1 June Call Repor LN in Fed Funds Purchased BS Naural log of fed funds purchased a minus he naural log of fed funds purchased a -1 June Call Repor LN in Fed Funds Sold BS Naural log of fed funds sold a minus he naural log of fed funds sold a -1 June Call Repor LN in Oher Borrowed Money BS Naural log of large business loans a minus he naural log of large business loans a -1 June Call Repor LN in Securiies BS Naural log of oher borrowed money a minus he naural log of oher borrowed money a -1 June Call Repor LN Large Business Loans BS Naural log of small business loans a minus he naural log of small business loans a -1 June Call Repor LN Small Business Loans BS Naural log of securiies a minus he naural log of securiies a -1 June Call Repor 18

22 TABLE 2: Banks wih Toal Asses < $500 million Dependen Variable: MSA Banks Non MSA Banks Deposis o asses Parameer Parameer Esimae value Prob > Esimae value Prob > Inercep < <.0001 Capial o asses < <.0001 Fed Funds purchased o asses < <.0001 Oher borrowed money o asses < <.0001 Naural log of asses o asses < <.0001 Number of branches < <.0001 Deposi marke share < Unemploymen rae < <.0001 Populaion growh rae < Naural log of per capia income <.0001 R-Square Number of observaions Roo-MSE Dependen Mean Coefficien of variaion Dependen Variable: MSA Banks Non MSA Banks Small business loans o asses Parameer Parameer Esimae value Prob > Esimae value Prob > Inercep <.0001 Deposis o asses < <.0001 Capial o asses < <.0001 Large business loans o asses < <.0001 Securiies o asses < <.0001 Fed Funds sold o asses < <.0001 Naural log of asses o asses < <.0001 Number of branches < <.0001 Deposi Herfindahl Unemploymen rae < <.0001 Populaion growh rae <.0001 Naural log of per capia income < <.0001 R-Square Number of observaions Roo-MSE Dependen Mean Coefficien of variaion Source: Auhors' calculaions. 19

23 TABLE 3: Banks wih Toal Asses < $500 million Dependen Variable: MSA Banks Non MSA Banks LN in Deposis Parameer Parameer Esimae value Prob > Esimae value Prob > Inercep LN in Capial < <.0001 LN in Fed Funds Purchased < <.0001 LN in Oher Borrowed Money < <.0001 LN in Asses < <.0001 Number of Branches a <.0001 Deposi marke share a Unemploymen rae Populaion growh rae Naural log of per capia income R-Square Number of observaions Roo-MSE Dependen Mean Coefficien of variaion Dependen Variable: MSA Banks Non MSA Banks LN Small Business Loans Parameer Parameer Esimae value Prob > Esimae value Prob > Inercep <.0001 LN in Deposis LN in Capial LN Large Business Loans < <.0001 LN in Securiies < <.0001 LN in Fed Funds Sold < <.0001 LN in Asses <.0001 Number of Branches a Deposi Herfindahl a Unemploymen rae <.0001 Populaion growh rae Naural log of per capia income R-Square Number of observaions Roo-MSE Dependen Mean Coefficien of variaion Source: Auhors' calculaions. 20

24 Federal Reserve Bank of Cleveland Research Deparmen P.O. Box 6387 Cleveland, OH BULK RATE U.S. Posage Paid Cleveland, OH Permi No. 385 Address Correcion Requesed: Please send correced mailing label o he Federal Reserve Bank of Cleveland, Research Deparmen, P.O. Box 6387, Cleveland, OH 44101