Economic History Association
Bank Rates of Return and Entry Restrictions, 1869-1914
Author(s): John J. Binder and David T. Brown
Source: The Journal of Economic History, Vol. 51, No. 1 (Mar., 1991), pp. 47-66
Published by: Cambridge University Press on behalf of the Economic History Association
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Bank Rates of Return and Entry
Restrictions, 1869-1914
JOHN J. BINDER AND DAVID T. BROWN
This articleuses a varietyof data in a simpleregressionframeworkto test various
hypotheses about the regionaldifferencesin U.S. bank rates of returnexisting
before 1915. We find that the observed pattern in the return differences is a
function of the measures of bank returns used in previous studies, regional
differencesin economic conditions,restrictionson interstatebranchbanking,and
private bank minimumcapital requirements.These results are inconsistent with
most of the bank monopoly-powerhypotheses in the literature.
numberof studies have found that bank rates of return(used as a
proxy for loan interest rates) in the rest of the country were
noticeablygreaterthan those in the Mid-Atlanticregionin the 1870s,but
the differencesdecreased over time and disappearedalmost completely
by about the turn of the century.' The differenceshave been attributed
to monopoly power, which, it is argued,was due to legal restrictionson
entry: for example, the prohibitionof branchbankingby nationalbanks,
minimumcapitalrequirementsfor nationalor state charteredbanks, and
the absence of general incorporationlaws for banks in some states.2
We extend previous researchby using a more appropriatevariableto
measure monopoly power, directly estimatingthe effects of the variables hypothesized to be entry barriers, examining the role of all
institutions that competed with national banks in the market for
commercialloans, and controllingfor regionalbusiness conditions. We
find that the regional differences in bank returnsdocumented in previous work were due to the way returns were measured and to a lesser
degree to regional differences in agriculturalreturns, restrictions on
A
The Journal of Economic History, Vol. 51, No. I (Mar. 1991). ?) The Economic History
Association. All rightsreserved. ISSN 0022-0507.
John J. Binder is Assistant Professorof Finance, Universityof Illinois-Chicago,Chicago, IL
60680. David T. Brown is Assistant Professorof Finance, Universityof Florida,Gainesville, FL
32611.
We would like to thanktwo anonymousreferees, Tom Weiss (the editor), RobertFogel, David
Galenson, Bob Korajczyk, Doug North, Sam Peltzman, Jon Pritchett, Greg Waymire, and
especially Gene Smiley for helpful criticism and discussions. Comments were received from
seminarparticipantsat Chicago, Claremont-McKenna,Florida,Illinois, Iowa, Tulane, MissouriSt. Louis, and Washingtonuniversities. We are grateful to the librariansin the Government
PublicationsUnit of the WashingtonUniversityOlin Libraryand the St. Louis FederalReserve
Bankfor theirassistance, to LindaBinderand ElisabethCase for editorialcomments,and to Carla
Stricklin for superb secretarial support. Excellent research assistance was provided by Ray
Gruender.
' Davis, "The InvestmentMarket,"was the first paperin this area.
2 See ibid.; Sylla, "Federal Policy"; James, "BankingMarketStructure";and James, "The
Developmentof the NationalMoney Market." Unless a distinctionis specificallymade between
states and territories,we use the term "state" to refer to both.
47
48
Binder and Brown
interstate branch banking, and minimumcapital requirementsfor private banks. Our results not only provide insight into the degree of
competition in banking before 1915, but also have implications for
present-daybank regulationand the nature of regulatorycompetition.
1. A DISCUSSION OF PREVIOUS WORK
Lance Davis calculated average rates of return on earning assets,
using data from the Comptrollerof the Currency'sAnnual Reports, for
national banks in six regions.3He reportedaverage gross and net rates
of return in each region for both reserve city banks (those located in
certain larger cities and required by the comptroller to hold higher
reserves than elsewhere) and country banks (those in all other places).
Gross rates of return (gross earnings divided by earning assets) were
calculated for each year from 1888to 1914and net rates of return(gross
earningsminus losses and operatingexpenses dividedby earningassets)
from 1869 to 1914.4Davis found that at the start of each period, both
gross and net returns increased as one moved farther away from the
Mid-Atlanticstates.5 Furthermore,the net and the gross returnsin the
various regions converged over time. Davis arguedthat the differences
were due to the greater monopoly power (caused by interstate branch
banking restrictions) of banks farther removed from the Mid-Atlantic
region and that the convergence in returns was due to the westward
expansion of the (substitute)commercialpaper market.
Richard Sylla hypothesized that minimum capital (equity) requirements, set for national banks in the National Banking Act of 1864,
restrictedbank entry in the smallest towns and caused the differencesin
returns.6The premise of this argumentis that within a certain range of
capital structures, there was an advantage to using debt financingand
that more banks in the western and central United States than in the
Davis's earningassets appearto be composed of the following:(1) loans and discounts; (2)
overdrafts;(3) U.S. bonds to secure circulation,deposits, and other U.S. bonds;(4) premiumson
U.S. bonds; (5) other bonds to secure deposits; (6) bonds, securities,judgments,claims, and so
forth; and (7) other real estate and mortgages.We are gratefulto Gene Smiley and (indirectly)
RichardSylla for identifyingthese components.The regionsare New England(Maine, Vermont,
New Hampshire,Massachusetts,Connecticut,and RhodeIsland),Mid-Atlantic(New York, New
Jersey, Pennsylvania.Delaware,Maryland,and the Districtof Columbia),South (Virginia,West
Virginia, North Carolina, South Carolina, Georgia, Florida, Alabama, Mississippi, Louisiana,
Texas, Arkansas, Kentucky, and Tennessee), Midwest (Ohio, Indiana,Illinois, Michigan,Wisconsin, Minnesota,Iowa, and Missouri),West (North Dakota, South Dakota, Nebraska,Kansas,
Montana,Wyoming,Colorado,New Mexico, and Oklahoma),and Pacific(Washington,Oregon,
California,Idaho, Utah, Nevada, andArizona).See Davis, "The InvestmentMarket,"pp. 356-57.
4 Bank operatingexpenses include interest paymentson deposits and other debt. See Smiley,
"InterestRate Movement."
5
Breckenridge,in "DiscountRates," examinedcommercialpaperratesfrom 1893to 1897in 43
U.S. cities and found a similarpattern.
6 The minimumcapitalfor nationalbankswas $50,000in cities under6,000 people, $100,000in
cities from 6,000 to 50,000 population,and $200,000in largercities.
Bank Rates of Return
49
East were denied this benefit by the legislated capital requirement.7
Sylla suggestedthat the Gold StandardAct of 1900,which decreased the
minimum required capital for national banks in the smallest towns,
reduced the entry restriction and caused the rate convergence.8 He
examinedbank returnsas well as other variablesaround1900and found
a number of changes largely consistent with reduced market power in
the bankingindustryat that time.
JohnJamesfoundthatthe gross returnon loansanddiscountsfor banks
was (controllingfor risk)directlyrelatedto monopolypower, measuredas
the numberof banksper capitain the market.9He emphasizedthe role of
laws affectingstate banksin theircompetitionwith nationalbanks, which
erected and then eliminated entry barriers.'0The passage of general
incorporationlaws for banksby manystatesafterthe mid-1880seliminated
the need for a specialcharterto incorporateas a state bank. Furthermore,
Jamesarguedthatminimumcapitalrequirementsfor state banksrestricted
entry, but a numberof states changedthese laws between 1895and 1909.
James found no evidence to support the Davis hypothesis that the
expansion of the commercialpaper marketled to convergence in bank
returns. He also noted that the convergence in returnsoccurredlargely
before 1900, which is inconsistent with Sylla's explanation. In fact,
James's estimates of gross rates of return on loans and discounts
indicated that the rate differencesincreased after 1900." He found that
rates of returnand the monopoly power of country nationalbanks were
positively related to state bank minimumcapital requirementsin 1909.
Based on these results, James concluded that "the erosion of local
monopoly power was due primarilyto the growthof state ratherthan of
national banks. The organization of state banks was encouraged by
7 Sylla also mentionedthe prohibitionof mortgageloans by nationalbanksin the 1864act as a
barrier.Whilethis prohibitionstoppedsome nationalbanksfromenteringthe marketfor mortgage
loans, it did not restrictentry in the commercialloan market(where nationalbanksoperated)and
thereforecannot explain regionaldifferencesin nationalbank returns.Since this prohibitionwas
not relaxed until 1913, it also cannot explain why the regionaldifferencesdecreased before that
year. Keehn and Smiley, in "MortgageLending,"discussed this issue in detail.
8 After 1900the minimumequity for nationalbanks in towns of less than 3,000 was $25,000.
9 James, "Banking MarketStructure," p. 461. Smiley, in "Interest Rate Movement," pp.
594-95, also correctedthe Davis estimates,by separatingout U.S. bondsandbankreservedeposits
fromotherassets, and calculatedgross returnsfrom 1888to 1913.Usingthe coefficientof variation
measuredcross-sectionallywith returnsfor the variousstates or reserve cities, he found no clear
decrease in this statistic over time and concluded that rates did not converge. The standard
deviation of rates does measuredispersionand would presumablyhave decreased over time as
rates converged.The averagerate, however, also decreasedover this period, so the coefficientof
variationmay not have. See ibid., tables A5 and A7. James, in "The Developmentof the National
Money Market,"pp. 879-80, made similarcommentsabout the coefficientof variation.
'0 Ibid., pp. 878-97.
l Ibid., figure 1. The rate in each regionwas comparedto the rate in the East, as definedin his
fn. 2. James showed that manyof the new nationalbankscharteredafter 1900,reportedby Sylla
as evidence of increasedentryafterthe Gold StandardAct loweredminimumcapitalrequirements,
were converted state banks. Therefore,the increase in nationalbanks overstates entry. Ibid., p.
890.
50
Binder and Brown
lower minimumcapital requirementsand also by the passage of general
bankinglaws in many states in the late nineteenth century."''2
Marie Sushka and Brian Barrett hypothesized that the viability of
substitute (equity) financing for certain businesses after 1885 broke
down the local bank lending monopolies.'3 They suggested that the
organizationof a departmentof unlisted securities by the New York
Stock Exchange in that year allowed the shares of firms far removed
from New York to reach the exchange. The results of a series of tests
using Davis's net rate of returndata were interpretedas consistent with
their hypothesis.14
All these empirical results are inconsistent with Sam Peltzman's
hypothesis that before 1935bankingmarketswere competitive.'5 With
respect to chartering, he stated that "state and Federal chartering
authorities operated independently of one another. . . . This legal
frameworkencouragedcompetitionbetween state and nationalauthorities in the issuance of charters.''16 He made a similar argumentwith
respect to capital requirements:"the Comptrollerof the Currency,the
charteringagent for national banks, responded to low state minimum
capital requirementsby successfully urging Congress to lower capital
requirementsfor national banks."'17
There are several problemswith these empiricalstudies. First, while
bank returns were extensively scrutinized, most of the studies did not
test the statisticalsignificanceof the regionaldifferencesor their change
over time. Instead, they visually examined the returns in the various
regions.18 Some of the hypotheses advanced were not explicitly tested
but instead were judged by anecdotal evidence about the existence and
change in legal and institutionalrestrictions.'9
Ibid., p. 896.
Sushkaand Barrett,"BankingStructure,"p. 473.
14
Several other empiricalstudies examined interest-ratedifferenceswith data from 1889 or
thereafter. Eichengreen, in "Mortgage Interest Rates" and Snowden, in "Mortgage Rates"
analyzed mortgage interest rates but reached different conclusions about whether regional
differenceswere due to monopoly power. Gendreau,in "The Risk Structure,"found that bank
loan rates and deposit rates across states were positively correlated, which he argued was
inconsistentwith bankmonopolypower. Pritchett,in "The RiskStructure,"pointedout, however,
thatmonopolypowerdoes not necessarilyconfermonopsonypower, so Gendreau'sresultsare not
necessarilyinconsistentwith bank monopolypower.
15 Peltzman,"Entry in CommercialBanking."
16 Ibid., pp. 11-12.
17 Ibid., p. 12. Hirshleifermade a similarargumentin "Towarda More GeneralTheory." It
should also be noted that the Modigliani-Miller
Theorem,which states that the firm'smix of debt
and equity is irrelevant,predictsthatlegislatedminimumswill not deterentry. See Modiglianiand
Miller, "The Cost of Capital."
18 James, "BankingMarketStructure"and James, "The Developmentof the National Money
Market"are exceptions.
19For instance, Jamesdid not relatebankreturnsor his monopolypowerindex to the existence
of general incorporationlaws in a state or (before 1909) to state bank minimum capital
requirements, nor did he attempt to explain changes in the former by changes in either
incorporationlaws or capitalrequirements.See James, "The Developmentof the NationalMoney
12
13
Bank Rates of Return
51
Second, the previous studies have focused incorrectly on interest
rates charged by banks (or proxies thereof) rather than the more
appropriate net return on total assets. In competitive markets with
certainty the net return earned by banks on their total investment
(assets) will equal the opportunitycost of capital. Otherwise entry or
exit will occur to equate these returns. Banks with monopoly power
would earn a greater net return on total assets because entry barriers
allow them to charge higherloan rates. Higherloan rates, however, do
not always imply monopoly power. Even with competition in each
region, banks in one area would set higherloan rates because they have
greater costs than banks elsewhere, or because they have a larger
proportion of nonearningassets, for example, currency. The point is
that higherloan rates could be an attemptto earn the normalnet return
on total investment in a competitive market.20Therefore, the net return
on total assets is the appropriatevariable to examine when testing
hypotheses about monopoly power. Only with this measure can we be
sure that regional differences reflect differentialmarket power.
Third, previous research has generally ignored the influence of
regional business conditions on bank returns. Low net returns in a
region might be due to a depressed local economy.21 The recent
financial problems of banks in the Northwest and Texas are good
examples.
Fourth, many competitorsof nationalbanks have escaped attention.22
Duringthe pre-WorldWarI period,the termstate bankexplicitlyreferred
to corporationsorganizedunder state law which, like national banks,
discountedcommercialpaper,receiveddemanddeposits,andhada capital
banks and, in some states, stock savings
stock. Private(unincorporated)
banks and trust companiesalso competed with nationalbanks for commercialloans and discounts. It is importantto examinethese institutions
because they were often subject to differentlaws than state banks with
respect to entry and/orminimumcapital.Table 1 shows the total number
of nationalbanks, state banks, privatebanks, and trust companiesin the
United States at five-yearintervalsfrom 1879to 1909.23
Market," pp. 893-96. The tests in Sushka and Barrett,"BankingStructure,"also sufferfrom a
numberof econometricproblems.See Smiley, "BankingStructure:A Comment"and Binderand
Brown, "Bank Rates of Return,"fn. 21, for a detailedcriticism.
20 As discussed above, in an attempt to measure the interest rate charged on loans, Davis
estimatedgross and net returnson earningassets and Jamesestimatedgross returnson loans and
discounts. Sylla and Sushkaand Barrettused the Davis gross and net returns,respectively,while
Odell, in "The Integrationof Regionaland InterregionalCapitalMarkets,"used the James data.
21 Since gross rates of returnincludeinterestreceived on loans, they are affectedby the state of
the regionaleconomy. James, in "BankingMarketStructure,"p. 456, attemptedto explaingross
returnswith farm revenue but found it had no explanatorypower.
22 Nationalbanksand theircompetitorsare discussed in Barnett,State Banks, pp. 9-11; Cator,
"TrustCompanies," schedule 2; Willis, AmericanBanking,pp. 12-19; and Sylla, TheAmerican
Capital Market, pp. 18-21.
23
Thereis a survivorbias in the Comptrollerof the Currencydataon nationalbanks, since data
52
Binder and Brown
TABLE I
NUMBER OF NATIONAL BANKS, STATE BANKS, PRIVATE BANKS,
AND TRUST COMPANIES, 1879-1909
National banks
State banks
Private banks
Trust companies
1879
1884
1889
1894
1899
1904
1909
2,048
813
2,545
37
2,625
1,017
3,458
44
3,239
2,097
4,215
63
3,770
3,705
3,844
228
3,583
4,253
4,168
276
5,331
6,984
5,484
924
6,893
11,292
4,407
1,079
Source: Barnett, State Banks, p. 201.
II. THE MODELS OF REGIONAL RETURN DIFFERENCES
As a first examinationof the magnitudeand statistical significanceof
the regional differences in bank returns and their convergence over
time, we estimated the equation:
Rit- RMAt= ail + ai2DI885t+ ai3DI900 + wit
(1)
where Rit is the average net returnfor country banks in region i during
year t (weighted by assets), RMAt is the average net returnfor country
banks in the Mid-Atlanticregion duringyear t, D1885, equals zero from
1869to 1885inclusive and one after 1885,D1900, equals zero from 1869
to 1900 inclusive and one after 1900, and wiitis the disturbanceterm.
The equation was estimated for each region (excluding the MidAtlantic) with annualdata for the period from 1869 to 1914.24Both the
Davis net returns and net returns on bank total assets were used as
dependent variables to show the effect of the different measures.
Countrybanks were used in all our tests to be consistent with James and
because the returndifferenceswere the greatest for those banks.25
If banks in region i earned higher returns than those in the MidAtlantic region before 1885, the intercept ail should be positive.
According to the Davis hypothesis, ai2 or ai3 should be negative in
region i dependingon when the commercialpaper market reached the
region. Under the Sylla hypothesis, bank marketpower was eroded by
the Gold StandardAct of 1900and ai3 would be negative in each region.
The James hypothesis predicts that ai2 and/or ai3 would be negative,
depending on when states in the region changed their banking laws.
Finally, underthe Sushka and Barretthypothesis, ai2 would be negative
for each region.
for insolventbanksare not reportedby the comptroller.The bias does not materiallyaffectour test
results, probablybecause in most states duringthe sampleyears the percentageof banksomitted
is fairly small. See Binderand Brown, "Bank Rates of Return,"pp. 9-11 and section 4.
24 The returndataare discussed in partA of the Appendix.The Mid-Atlantic
regionwas used as
a reference point because it generally had the lowest average bank returnsand was used as a
benchmarkin other studies.
25 See Davis, "The InvestmentMarket,"figures2, 4.
Bank Rates of Return
53
To test directly the various hypotheses, assume that bank net returns
on total assets in each state i duringyear t are given by:
J
+
Rit= ca1o
a FRBKit+ a2STMINit+ a3PMINit+
E aj+3BCit + cit
j=1
(2)
where FRBKi,equals zero if there was free bankingin state i at the start
of year t and one otherwise, STMINi, is the smallest of the minimum
capital requirementsfor state chartered institutions with commercial
bankingpowers in the smallest towns in i at the start of year t, PMINi,
is the minimumcapital requirementfor private banks in the smallest
towns in i at the start of year t, BCij,is the value of the jth measure of
business conditions in state i during year t, and ji, is the disturbance
term.
A state is defined as having had "free banking" at a given time if a
general incorporationlaw for banks was in effect and the state prohibited special charters to incorporate commercial banks.26Since stock
savings banks and trust companiesthat had commercialbankingpowers
were, with the possible exception of their minimum capital requirements, similarto state banks these institutionsare groupedtogether. In
each state STMINi,equals the smallest of the minimumcapital requirements set for these three types of organizationsin the smallest towns.27
Private banks were unincorporatedand are treated separately; therefore, PMINi, is includedas a furtherexplanatoryvariable.The intercept
a1ois allowed to differacross states because Davis and Sylla arguedthat
branchbankingrestrictionsand nationalbank minimumcapital requirements, which were the same in each state, affected banks in each area
differently.
Subtractingthe arithmeticaverage net returnRMAt for states in the
Mid-Atlanticregion from Ri, in equation 2 yields the following:
Rit = a1o - aMAo
+ ajFRBK*
+
+ a2STMIN*+
a3PMIN*
(3)
: aj+3BCyt
+ e*
j=I
where for any variable Xi,, X* equals Xi, minusXMA,; and aMAOis the
average intercept in equation 2 for states in the Mid-Atlanticregion.
26
In many states special charteringcoexisted at one time with a general incorporationlaw,
implyingthat the general law was disadvantageousand that free entry did not, in reality, exist.
Barnett,State Banks, p. 29. The state bankinglaws and the collectionof these data are discussed
in an appendixwhich is availableon request.
27 In several states the minimumcapitalrequirementsfor trust companies, savings banks, and
state bankswere, like those for nationalbanks,positivelyrelatedto the size of the town wherethey
were located. FollowingJames,in "The Developmentof the NationalMoneyMarket,"pp. 892-95,
we used the requirementfor institutionsin the smallesttowns.
54
Binder and Brown
When data from both before and after 1885and 1900are used, equation
3 is extended to allow the interceptand the coefficientson the monopoly
power variablesto change in the mannerhypothesized by Davis, Sylla,
and Sushka and Barrett.28
Ril = go + fID1885, + 2D1900,+ 33FRBK1, + 4STMINt
(4)
+ 535PMIN*,
+ f36D1885,*FRBK*, + 837DI885,
* STMIN*
+
>
j+7-BCy,+ U.,
1=I
Equation 4 was estimated using several cross-sections of data from
both before and after 1885and 1900.Any state without solvent country
national banks (no returndata) or with any other missing observations
during the year was excluded from the sample. If state charteringof
commercialbanks or formationof private banks was illegal at the start
of the bank year, the state was also excluded.29
Equation4 includes measuresof business conditions in the individual
states as explanatory variables. Given the paucity of data on these
conditions before 1900,we used the net rate of returnin agricultureand
manufacturingfor individual states. Unfortunately, these data come
from the decennial census and our sample is confined to those years.30
Since the dependentvariablein equation4 measuresthe differencein
bank returns between state i and the Mid-Atlanticstates, under the
Davis hypothesis go would be greater than zero because banks in the
regions fartherfrom New York City had greater market power. If the
spread of the commercial paper marketafter 1885 and 1900 decreased
bank monopoly power, 131and /2 would be negative.3' The Sylla
hypothesis predicts that because of capital requirementsfor national
banks, go3would be greater than zero. If bank monopoly power
decreased when national bank capital requirementsdecreased (in the
smallest town) in 1900, then 12 would be less than zero.
Following James if the absence and later passage of free bankinglaws
28
Normally,the productof D1885,andPMIN*,would have been includedin equation4 to allow
f35to change after 1885,as was done for /33 and f4. There are, however, only two states where
PMIN*,does not equal zero before 1886.Therefore,D1885,times PMIN*Jis highlycollinearwith
PMIN* and is excludedfromthe equation.This causes no problemin hypothesistesting, since this
simply means that privatebank minimumcapitalrequirementswere unimportantbefore 1886.
29 Whileno minimumcapitalrequirements
were set for enteringincorporatedor privatebanksin
that state, it is inappropriateto code these variablesas zero. The Districtof Columbiais excluded
from the samplebecause each state charteredbanklocatedtherewas incorporatedby and subject
to the laws of the surroundingstate of its choice, thus confusingthe measurementof the state
bankinglaw variables.The Indianterritoryis also excludedbecause it appearsthat it had no laws
concerningcorporationsbefore about 1901.See Cator, "TrustCompanies,"schedules 5, 6.
30
The census data are discussed in the Appendix.
31 Davis, in "The InvestmentMarket,"p. 372, discussedthe westward
expansionof this market
from the early 1880sinto the early 1900s.
55
Bank Rates of Return
TABLE
2
A SUMMARY OF THE HYPOTHESES TESTED IN EQUATION 4
Predictions
Hypothesis
/30 > 0, 31 <0,
/30 > 0, 2 < 0
Davis
Sylla
James
Extended James
Sushka and Barrett
Peltzman
[32
<
0
[3 > 0, /4 > 0
> 0, /4 > 0? /35 > 0
/3w1/6 and/or /7 < 0
= 0
30= 31= ...=37
[3
Source: See the text.
caused bank returnsto differand then converge, /33 would be positive.
Similarly, if bank return differences were due to state bank minimum
capital requirements,/34 would be positive. Underthe James hypothesis
the state bankinglaws, ratherthan their effects, changed over time and
therefore 136 and /37 should be zero. If, as an extension of the James
hypothesis, private bank minimumcapital requirementsrestricted entry, 535
would also be greater than zero. Under the Sushka and Barrett
hypothesis, f31, 136, and/or /37 would be negative, since they argue that
bank monopoly power decreased after 1885; that is, regional bank
returndifferencesdecreased or were no longer due to the state banking
laws as discussed by James. If the Peltzman hypothesis that banking
was competitive is correct, go3through/37 should all equal zero. These
hypotheses are summarizedin Table 2.
The hypothesis tests in equation4 overcome the problemsin previous
work because: (1) the equationis estimatedusing net rates of returnon
total bank assets, (2) the effects of regional business conditions are
explicitly controlled for, (3) the effects of state chartered institutions,
other than state banks, and private banks are incorporated in the
equation, and (4) the effects of the variables hypothesized to be entry
barrierson bank returnsare explicitly tested.
III. EMPIRICAL EVIDENCE
A. Time-SeriesResults
Table 3 reportsthe results from estimatingequation I for each region
with both the Davis net returndata and the net returnon total assets.32
32 In almostevery case the Whitetest rejectedhomoskedasticity,
and/orthe Durbin-Watsontest
found significantpositive autocorrelationof the disturbances.See White, "A HeteroskedasticityConsistentCovarianceMatrixEstimator."Whenthe disturbanceswere heteroskedastic,we used
weightedleast squares.Whenthe disturbanceswere autocorrelated,the equationwas re-estimated
usingPROCARIMA(see SAS Institute,SASIETSUser's Guide)to modelthe errorsas an ARIMA
process. When both problems are detected in the ordinary-least-squaresresiduals, we first
estimatedequation 1 with weightedleast squares,and if the Durbin-Watsontest was significantor
inconclusive, we used the weightedobservationsin PROCARIMA.
Binder and Brown
56
TABLE 3
THE BEHAVIOROF REGIONALRETURN DIFFERENCES,1869-1914
Region
akl
&i2
&i3
Davis Net Returns
New Englandab
SOUthb
Midwest
West ab
Pacificab
0.0067
(3.50)
-0.0063
(3.26)
-0.0005
(0.37)
0.0087
(6.27)
0.0105
(11.20)
0.0097
(2.51)
0.0377
(4.70)
0.0005
(0.24)
-0.0079
(5.76)
-0.0066
(1.13)
-0.0306
(3.35)
0.0007
(0.32)
-0.0011
(0.74)
0.0078
(1.65)
0.0019
(0.40)
Net Returnson Total Assets
New Englandab
0.0072
(4.08)
-0.0054
(2.97)
-0.0015
(1.57)
South
0.0055
(3.69)
0.0077
(7.72)
0.0006
(0.33)
-0.0059
(4.12)
0.0029
(0.56)
-0.0159
(4.10)
-0.0003
(0.28)
-0.0025
(2.20)
0.0034
(0.97)
0.0007
(0.28)
MidweSta b
WeSta
b
Pacifica
-0.0017
(0.38)
0.0183
(6.21)
Weighted least squares was used to estimate the equation, since the White test rejected
homoskedasticity.See fn. 32.
b
The estimationproceduretook accountof autocorrelateddisturbances,since the Durbin-Watson
test rejectedindependence.See fn. 32.
Note: The figuresin parenthesesare t-statistics.The regressioninterceptis ail, ai2 is the coefficient
of the variableD1885, and cy3 is the coefficientof the variableD1900.
Source: Estimatesof equation 1.
a
When the Davis data are used, the intercepts are all positive and
statistically significant.For the first four regions, the intercept is in the
neighborhoodof 0.01, indicatingthat annualbank returnsin those areas
exceeded returns in the Mid-Atlantic region by about I percent on
average from 1869 to 1885. For the Pacific region, the difference was
almost 4 percent per annum. The average value of the five intercepts is
0.0147 with the Davis data.
There is evidence that the differencesdecreased after 1885, since aCi2
is significantly negative for the New England, Midwest, and Pacific
regions. The average value of this coefficientestimate is -0.102 for the
five regions. There is no evidence of further convergence after 1900
since none of the ^i3's are statistically significant. As opposed to the
inferences Davis drew by looking at time-series plots, the bank returns
did not converge over time in every region.
The second part of the table presents the results using net returnson
total assets. The estimates of ail are generally smaller than those
57
Bank Rates of Return
obtained with the Davis returns, especially in the West and Pacific
regions, indicating that the assets not counted by Davis were more
importantin the latter regions than elsewhere. In fact, the estimated
intercept is statistically insignificantfor the West, while it is significant
for the other regions. With this data, the average value of the intercepts
is 0.0074, only about half as large as in the first part of the table.
As with the Davis data, the returndifferencesdecreased significantly
after 1885 in the New England, the Midwest, and the Pacific regions.
But the average value of 5i2, -0.0047 is only about half as large as that
obtained using the Davis data. There is, however, evidence that the
returndifference for the Midwest decreased significantlyafter 1900, as
predictedby Sylla. In sum, while the returndifferencesbefore 1886and
their decline afterwardare noticeably smaller when the returnon total
assets is used, the results are otherwise fairly similarto those obtained
with the Davis data.
B. Cross-Sectional Time-SeriesTests
Equation4 was estimatedwith bank returnsfor the years 1870, 1879,
1889, 1899, and 1909and agriculturaland manufacturingreturnsfor the
correspondingyears from the census data.33The estimated equation is
as follows:
Ret= 0.002 + 0.00ID1885t+ 0.002D1900t- 0.001FRBK*
(0.40)
(1.72)
(1.57) (0.41)
(5)
+ 2.29PMINM+ 0.00ID1885t*FRBK*
0.079STMINM
(0.35)
(3.13)
(0.23)
-
-
0.695D1885t * STMINM+
(1.47)
R2= 0.102
0.013AG* - 0.006MAN*
(1.83)
(0.72)
s(0) = 0.008
N= 179
The figures in parentheses are t-statistics.34 The monopoly power
hypotheses do not fare well; only the estimatedcoefficienton PMIN* is
significantlydifferentfrom zero. Of the two variables measuringstate
economic conditions, the estimatedcoefficienton the agriculturalreturn
difference is positive and reliably differentfrom zero.35
33 These bank years correspond most closely to the reportingperiod in the census for the
agriculturaland manufacturingreturns.See the Appendix.
34 In equations 5 and 6 the t-statistics are based on a consistent estimate of the disturbance
CovarianceMatrixEstimator,"
covariancematrix.See White, "A Heteroskedasticity-Consistent
pp. 817-21. STMIN*,and PMIN*,were dividedby 10 millionto make them conformablewith the
other variables. Diagnostic tests did not find that the explanatoryvariablesin equation 5 were
highlycollinear. See Belsley et al., RegressionDiagnostics.
15 A potential problem with equation 5, pointed out by an anonymous referee, is that
manufacturing(agricultural)returnsmay have become more (less) importantin explainingbank
returnsover time as the manufacturingsector expandedrelativeto agriculture,but our equation
58
Binder and Brown
There were other restrictions on state chartered and private banks
beyond those tested in equation5 that are also of interest. As discussed
above, states that prohibited the charteringof commercial banks or
organizationof privatebanksat the startof the bank year were excluded
from the sample because the minimumcapitalrequirementvariablewas
meaningless. Incorporationof commercialbanks was prohibitedeither
by state law or in the territoriesby an act of Congressuntil 1885.36Entry
by private banks was prohibitedby state law.37Perhaps these prohibitions restrictedentry by state institutionsand allowed federalchartering
authoritiesto cartelize nationalbanks, increasingnationalbank returns
in those states.38
To examine these restrictions, the minimum capital requirement
variablesin equation5 were droppedand qualitativevariablesindicating
when entry by incorporated or private banks was prohibited were
included. The results for this formulationare as follow:
+ 0.002FRBKt
Rt = 0.002 + O.00ID1885t+ O.OOID19OOt
(1.82) (0.42)
(1.01)
(0.47)
+ O.O1ONOSTt+ 0.002NOP* -
(1.11)
-
(0.63)
(6)
0.004D1885t * FRBK*
(1.38)
0.00ID1885t*NOSTt + 0.018AGt - 0.009MAN*
(0.11)
(1.55)
(0.73)
R2 = 0.091
s(zt) = 0.O11
N= 218
where NOST*,equals NOST1,minus NOSTMAtand NOP, equals NOPi,
minus NOPMA,, NOST,, equals one if all types of state incorporated
holds the coefficients constant. To assess this bias, equation 5 was re-estimatedusing a single
businessconditionsvariable,the weightedaverageof the returnson agricultureand manufacturing
in the state, with the weightbeingeach sector's shareof capitalinvested. This takes accountof the
importanceof each activity in the state and lets the weights vary over time. The estimated
coefficienton this variablewas not, however, reliablydifferentfrom zero at the 5 percent level.
This may be because country banks were still largelyin agriculturalareas even by 1909.
36 See Barnett, State Banks, pp. 23-28. The states in which the incorporationof commercial
banks, includingtrust companiesand stock savings banks with commerciallendingpowers, was
prohibitedafter 1868were almost all in the West and Pacificregions.
37 To Jan. 1, 1909, the following states (duringthe years shown) prohibitedorganizationof
private banks: Colorado (1877-1879). North Dakota (1890-1909), South Dakota (1891-1892),
Oklahoma(1879-1909),and Kentucky(1906-1909).
38 In 1879, when state incorporatedbanks were still illegal in the territories,Dakota had four
nationalbanks;Montana,Wyoming,and New Mexico hadtwo; Utah, Washington,and Idahohad
one; and Arizonaand the IndianTerritoryhadnone. The Officeof the Comptrollerof the Currency
has had discretionarypowerto grantnationalbankcharterssince its inceptionand the issuance of
a charterwas heavily influencedby politics. For instance, AmericanBanker'sAssociation, The
Bank CharteringHistory,p. 11, noted thatapplicationswere routinelysent to the congressmanfor
the districtto solicit his opinion. See also Peltzman,"Entryin CommercialBanking,"pp. 11-12;
U.S. Boardof Governorsof the FederalReserve System, TheDual BankingSystem, p. 123;and
Huntingtonand Mawhinney,Laudsof the UnitedStates [NationalCurrencyAct of 1864,sections
12, 17, 18], on the comptroller'sability to deny charters.
Bank Rates of Return
59
commercial banks were prohibitedfrom entering at the start of year t
and zero otherwise, NOPi, equals one if private banks were prohibited
from forming in the state at the start of year t and zero otherwise, and
NOSTMA, and NOPMA, are the arithmetic averages of NOST1, and
NOPi, for the Mid-Atlanticstates.
Where state incorporationof banks was prohibited, FRBKi, equals
one, so the coefficient on NOST* measures the marginaleffect (beyond
that of special chartering)on national bank returns of the absence of
entry by state chartered banks. This coefficient is allowed to change
after 1885 by including the interactive variable D1885, times NOST*.
The effect of prohibiting entry by private banks is captured by the
coefficient on NOP*.39 If either restriction increased national bank
monopoly power, these coefficients would be positive. If prohibiting
entry by state charteredinstitutionsdid not affect nationalbank returns
after 1885, the coefficienton the interactivevariablewould be negative.
The figures in parentheses are asymptotic t-statistics based on a
consistent estimate of the covariance matrixof the disturbances.40
As in equation 5, most of the estimated coefficients on the monopoly
power variables in equation 6, including the ones that measure entry
prohibitionsfor incorporatedor privatebanks, are not reliablydifferent
from zero. The estimatedintercept, which only borderedon significance
in equation 5, is significantlygreater than zero. Equation 6 provides a
more powerful test of the hypothesis that returns were on average
smaller in the Mid-Atlantic region before 1886, because the sample
contains more observations for the Pacific states before 1886 where
bank returnswere the largest(see Table 3). The estimatedcoefficienton
the agriculturalreturnborders on significanceat the 5 percent level in
equation6, while the returnon manufacturingagainhas no explanatory
power.4'
To summarize,the results from these two equations are inconsistent
with the Sylla, James, and Sushka and Barretthypotheses. The regional
differences in returns before 1886, captured by the intercepts in equations 5 and 6, are consistent with branchbankingrestrictionsdeterring
entry as hypothesized by Davis. This, however, is only partof his story;
the spreadof the commercialpapermarketdid not eliminatethe regional
differences as he predicted, since the intercepts do not decrease over
As with PMIN*,in equations4 and 5 (see fn. 28), the productof D1885, and NOP*,is not
includedin equation6 because in the sample it is highly collinearwith NOP*,.That is, only one
state prohibitedprivatebanks before 1885. See fn. 37.
40 Diagnostic tests revealed that there was not a high degree of collinearity among the
explanatoryvariables.
41 It is surprisingthat the restrictionon privatebankentry had no effect, since there is evidence
in equation 5 that private bank minimumcapital requirementswere positively correlatedwith
national bank returns. The former test is (relatively)not very powerful, since only four states
restrictedprivatebank entry duringthe sample years, while 16 set privatebank minimumcapital
requirements.
60
Binder and Brown
time. Finally, returns were affected by private bank minimumcapital
requirements, which is consistent with an extension of the James
hypothesis, but there is no evidence that national bank returns were
higher in states where entry by state chartered or private banks was
illegal 42
The evidence of monopoly rents does not agree with the Peltzman
hypothesis of competition in banking. It should be remembered,however, that the two factors that were important,branchingrestrictions
(which caused an average returndifference of 0.002) and private bank
capital requirements(which existed in only a few states primarilyafter
1885)had only minoreffects on U.S. bankson the whole. Therefore,the
picture painted by Peltzman is a reasonably accurate one.43
Since we find little support for the previous theories, what explains
the pattern of regional differences? First, as already discussed, about
half of the regional differences and the convergence between 1886 and
1900 observed by earlier researchers is due to the choice of measure.
What remains is a function of three factors: regional differences in
agriculturalreturns, the lack of branchbankingby nationalbanks, and
private bank minimumcapital requirements.
Interstatebranchbankingrestrictions,representedby the constant in
equation 5, caused bank returnsto be greaterin the rest of the country
than in the Mid-Atlanticregion by about 0.002 on average throughout
this period. The variableAGO*
accounts for partof the averagedifference
in bank returns in the period 1869 to 1885 and as the differences in
agriculturalreturns decreased over time, they contributedto the convergence of bank returns after 1885. Private bank minimum equity
requirementswere unimportantbefore 1885, but they explain a portion
of the decrease in the average difference after 1885.44Together these
three factors explain22 percentof the averagedifferencein bankreturns
before 1886and 18 percent of the decrease after 1885that appearin the
42 An alternativeexplanationof the statisticalsignificanceof the interceptand the coefficienton
the agriculturalreturndifferencein equations 5 and 6 is that they are capturingthe effects of
regionaldifferencesin bank asset risk. This, however, does not appearto be the case. Since we
examinedrealizedratherthanpromisedreturns,only beta riskis relevant(see the discussionof the
CapitalAsset PricingModelin Fama,Foundationsof Finance, chap. 8). Using the annualaverage
net returnon total assets for countrybanksin each region, beta was estimatedwith two different
marketindexes: the annualreturnson the Cowles All Stock Index (1872-1914)and U.S. railroad
net earningsdividedby trackmiles (1871-1911). The beta estimatesfor the variousregionsdiffered
significantlyfromthe estimatefor the Mid-Atlanticregionin only one case out of ten. In that case,
the differencewas only 0.032.
43 The fact that some restrictionsaffectedbankreturnsindicatesthat either national,state, and
privatebankswere perfectsubstitutesand the variousregulatorscooperatedwith one another,or
these institutionswere imperfectsubstitutes.In the formercase and undersome conditionsin the
latter,this shows thatthere was not sufficientregulatorycompetitionin organizingbanksto ensure
a perfectly competitive industry. Since the monopoly rents were small, there must have been a
large degree of regulatorycompetition.
44 In 1870the minimumin all states was zero and in 1879it was greaterthan zero in only two
states.
Bank Rates of Return
61
Davis data. The combination of these three variables and the more
appropriatenet returnon total assets explains 72 percent of the average
differencebefore 1886and 64 percent of the decrease in that figureafter
1885.45
IV. THE POLITICAL ECONOMY OF MINIMUM CAPITAL REQUIREMENTS
We findno evidence that minimumcapitalrequirementsset by federal
or state authorities for incorporatedbanks served as an entry barrier.
Nor is it clear that there was much pressure by potential entrants to
have the minimums decreased. For example, on February 24, 1876,
John Jay Knox, then Comptrollerof the Currency, correspondedwith
the Senate Committeeon Finance about a bill (S.75) which would have
lowered the minimumcapitalrequirementfor nationalbanks in towns of
greater than 6,000 people to $50,000.46He argued that the change was
largely unnecessary for "it rarely happens that applications are made
for the organizationof banks of a less capital than $100,000" in towns
where the requiredminimumwas $100,000.47
Nonetheless, capital requirementswere a controversial political issue. At various times in several states the bank supervisorscampaigned
against lowering the minimumor in favor of raisingit.48With respect to
the national bank system, the Indianapolis Monetary Commission of
1897called for "a diminutionof the minimumcapital requiredfor banks
in places of small population, and authority for the establishment of
branch banks."49 Although branch banking proved politically infeasible, the support of the comptrollerled to a minimumcapital of $25,000
for nationalbanks in towns of less than 3,000 in the Gold StandardAct
of 1900.50
Why was there such an intense debate about changing minimum
capital requirementsif they did not affect entry and profitability?One
explanation is that while a change in the capital requirementmay not
have affectedthe value of the firmas a whole, it could have redistributed
" All threeof these variablesappearin equation5. In the cross-sectionaltime-seriessampleused
to estimate the equation, the bank returndifferencesfollow a patternover time similarto that
observed in the time-series data in the bottom panel of Table 3. That is, the average return
differencebefore 1886and the decreasein thataverageafter 1885are comparablein these two data
sets. Therefore,we used the data and coefficientestimatesfromequation5 to assess how muchof
the patternin the Davis net returnswas due to these three variables.
46 See fn. 8.
47 See Knox, "Letter to the Chairman."At various times the comptrollerhad the power to
recommendto the treasurysecretarythat charterapplicationswith a capital below the required
minimumbe approved.See the National CurrencyAct of 1864and Heinberg, The Officeof the
Comptroller, p. 21.
See Cooke, "BranchBanking,"pp. 100-2;and Barnett,State Banks, p. 40.
Sylla, in TheAmericanCapitalMarket,pp. 70-72, discussed the Indianapolisconventionand
its aftermath.
so AmericanBanker'sAssociation, TheBank CharteringHistory, pp. 15-17, noted the political
controversyover this issue.
48
49
62
Binder and Brown
wealth among securityholders. For example, assume a bank with two
classes of claimants, depositors (debt) and stockholders (equity), and
that within a class each claim is identical. Assume that deposits are risky
and that the market value of the firm (the sum of the debt and equity
market values) is unaffected by a change in the required amount of
capital. If regulatorsincreased the minimumcapital requirement,then
an affected bank would not change its investment decisions but would
use the new equity capital to decrease its debt. The marketvalue of the
remaining debt would increase, since the probability of bankruptcy
would decrease. Symmetrically,the holders of the old equity would
experience a decrease in wealth.52
Stockholders and bondholders of an existing bank would therefore
experience changes in their wealth when the bank altered its capital in
response to a change in the required minimum. This analysis also
predicts that when the minimum capital standard for national banks
decreased, as it did for those in the smallest towns in the Gold Standard
Act of 1900, a number of state banks would have converted to the
national chartering system because the stockholders' benefits (costs)
from switching had increased (decreased). A large number of state
banks did in fact convert at that time.53
V. SUMMARY AND IMPLICATIONS
We have shown that regional differences in bank returns during the
period 1869 to 1914 cannot be explained by monopoly power because
most legal restrictionson bankinghad no effect on bank net returnson
total assets. The returndifferencesdocumentedin previous studies are
due primarilyto the measures of bank returnsused by other researchers. Our evidence is consistent with the notion that banking markets
during this period were highly competitive and have implications for
bank regulationtoday. As in the period 1869to 1914, state and federal
regulators currently set minimumcapital requirementsin one form or
anotherfor incorporatedbanks under their control. Our findingslessen
concern that present-daycapital requirementsserve as an entry barrier.
Our understandingof the industry's performance in the late nineteenth century is still incomplete. The exact nature of the competition
that kept down national bank returns in areas where state chartered
commercial banks were prohibited is unclear, although we suspect
privatebankerssuppliedthe necessary competition. Moreover, the role
of transactions costs has not been adequately investigated. Our cross5' This is a well-known result in the theory of finance. See Galai and Masulis, "The Option
PricingModel," appendix2; and Fama and Miller, The Theoryof Finance, pp. 151-52.
52 It is assumedthat the changein the capitalrequirement
was unanticipated,since in an efficient
capital marketany anticipatedchange would alreadybe reflectedin security prices.
" Evidence on this switch to nationalbankingis in Cooke, "BranchBanking,"pp. 106-7.
Bank Rates of Return
63
sectional time-series tests indicated that branching restrictions and
regionalbusiness conditions had some influence,but those results could
also be due to transaction costs in moving capital between regions.
These costs could account for both a significantconstant differenceand
a significantcorrelationbetween bank returnsand agriculturalreturns,
since farm returnswould also be higher in the West.54
Appendix
BANK AND OTHER RETURN DATA
A. Bank Returns
Net earningsand total assets for countrynationalbankswere collected fromthe 1869
to 1914editions of the Comptroller'sAnnualReport. In equation 1, net earningsfrom
1870to 1906are for the year endingAugust31. In 1907the comptrollerswitchednational
banks to a June 30 fiscal year. For that year, the earnings figure is for the period
September 1 to June 30. From 1908to 1914the net earningsare for the June 30 fiscal
year. For 1869, only six month's earnings (ending August 31) are available and this
numberwas doubledto obtainearningsfor the year. These periodsare the same as those
apparentlyused by Davis. The AnnualReportsgenerallycontainbalancesheet data for
five dates duringthe year. Total assets for each state were taken from the last balance
sheet in each volume, which is fromaboutthe firstof October.The weightedaveragenet
returnfor country national banks in each region was calculated as the aggregatenet
revenue of banks in the region divided by the aggregateassets of those banks.
In equations 5 and 6 country nationalbank net earningsfor the 12 months ending
August 31 were used in the years 1870, 1879, 1889,and 1899.For 1909,net earningsare
available for the calendaryear and these were used, since the 1910census measured
agriculturaland manufacturingnet revenuesfor the 1909calendaryear. Total assets are
from the last balance sheet in each year's AnnualReport.
B. Regional Business Conditions
The 1870 census contains estimates of the value of farm products and labor costs
(primarilyfor the year 1870)as well as estimates of the value of farms, implements,
machinery, and livestock at the start of the census collection period for the various
states.55The weightedaveragereturnon farmsfor each state in 1870was calculatedby
subtractinglaborcosts fromthe value of productsand dividingthis figureby farmcapital
(the sum of the value of farms, implements,machinery,and livestock).
The 1880, 1890, 1900,and 1910censuses containestimates by state of the total value
of all farm products and fertilizer costs for the previous calendar year as well as
estimates of the value of farms (includingland, fences, and buildings), implements,
" Withthe exceptionof Breckenridge,who arguedthattransactioncosts were so largethatthey
precludedthe interregionaltransferof capital, this explanationappears to have received little
attentionin the literature.See Breckenridge,"Discount Rates."
" This section is based on the discussion surroundingthe collection of the census data in U.S.
Bureau of the Census, Census of the United States.
64
Binder and Brown
machinery,and livestock at the startof the census collection period.The 1900and 1910
censuses, like the 1870census, reportfarmlabor costs for the year in question but the
1880 and 1890 censuses do not. For 1899 and 1909, agriculturalnet revenue was
calculatedby subtractingfertilizerand laborcosts from the value of farmproductsand
divided by farmcapital to obtain the weighted average returnon farms for each state.
Laborcosts for 1879and 1889were estimatedby multiplyingfarmcapitalin that year by
the ratio of labor costs to farmcapital in 1870and 1899,respectively. These estimates
were used to calculate the weighted average returnson farms for 1879and 1889.
The 1870, 1880, 1890, 1900, and 1910 censuses contain estimates of the value of
products sold, costs of materialsused, wages paid, and the value of capital in use by
manufacturingfirms for the various states. For 1870, 1880, and 1890, the census
measuresactivity for the 12 monthsendingMay 31 of that year and the value of capital
appearsto be measuredas of that point. For the 1900census, each firmreportedfor its
fiscal year endingclosest to (but before)June 1, 1900,and capitalwas fromthe last day
of that year. In the 1910census, flows are for the calendaryear 1909and the capital
stock is for the last day of 1909.Manufacturingnet revenue is calculatedfor each state
by subtractingwages and materialcosts from the value of products. The weighted
average return on manufacturingin each state is the net revenue figure divided by
manufacturingcapital for the state.
C. Railroad and Stock Returns
Stock returnswere calculatedfor the same calendarmonths as the bank returnsby
taking the percentage change in the Cowles All Stock Index including dividends
between the relevantmonths.56Forexample, bank returnsbefore 1907were calculated
for the year ending August 31; therefore, stock returnsfor those years were measured
using August values for the Cowles Index.
Net earningsand miles of maintrackin operationfor U.S. railroadsfrom 1871to 1911
were taken from various editions of Poor's RailroadManual.57Theearningsfigurefor
each railroadin year t came from the correspondingfiscal year. The trackfigureis that
in existence for each firmat the end of the fiscal year.
56
57
See Cowles,CommonStock Indexes.
Poor,Manualof the Railroads.
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