Berger - 2006 - Technological Progress and The Geographic Expansion of The Banking Industry

ALLEN N.
BERGER ROBERT DEYOUNG
Technological Progress and the Geographic Expansion of the Banking Industry

We test some predictions about the effects of technological progress on geographic expansion using data on banks in U.S. multibank holding companies over 1985-98. Specically, we test whether over time (1) parental control over afliate banks has increased and (2) the agency costs of distance from the parent have decreased. The data suggest that banking organizations control over afliates has been increasing over time and that the agency costs of distance have decreased somewhat over time. The ndings are consistent with the hypothesis that technological progress has facilitated the geographic expansion of the banking industry. JEL codes: G21, G28, G34, L11 Keywords: banks, efciency, mergers, productivity, technological progress.
Over the past few decades, the banking industry has been in a constant process of geographic expansion, both within nations and across nations. At one time, nearly all customers were served by locally based institutions. In contrast, it is now much more likely that the bank or branch providing services is owned by an organization headquartered a substantial distance away, perhaps in another state, region, or nation. To illustrate, between 1985 and 1998 the distance between the largest bank and the other afliate banks in U.S. multibank holding
The opinions expressed do not necessarily reect those of the Federal Reserve Board, the Chicago Reserve Bank, or their staffs. The authors thank Bruno Biais, Bill Brainard, Neil Esho, Mark Flannery, Dan Gropper, Chris James, Loretta Mester, Steven Ongena, Marco Pagano, Fabio Panetta, Tony Saunders, Rick Sullivan, John Wolken, Oved Yosha, two anonymous referees, and other participants at the JFI Symposium on Corporate Finance with Blurring Boundaries Between Banks and Financial Markets, the Yale University Conference on The Future of American Banking: Historical, Theoretical, and Empirical Perspectives, and the Federal Reserve Bank of Chicagos Bank Structure and Competition Conference for helpful comments, and Nate Miller and Phil Ostromogolsky for outstanding research assistance.
Allen N. Berger is a Senior Economist of the Board of Governors of the Federal Reserve System and Wharton Financial Institutions Center (E-mail: abergerfrb.gov). Robert DeYoung is Associate Director, Research Branch, at the Federal Deposit Insurance Corporation (E-mail: rdeyoungfdic.gov). Received March 31, 2003; and accepted in revised form December 7, 2004. Journal of Money, Credit, and Banking, Vol. 38, No. 6 (September 2006) Copyright 2006 by The Ohio State University
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companies (MBHCs) increased by over 50% on average, from 123.35 to 188.91 miles, as many MBHCs acquired banks in other states and regions. The role of deregulation in the geographic expansion of this industry is well understood. In the United States, a series of deregulations in the 1980s and early 1990s removed restrictions on intrastate and interstate banking, culminating with the Riegle-Neal Interstate Banking and Branching Efciency Act of 1994, which permitted interstate branching in almost all states as of June 1997. In the European Union, the set of actions known as the Single Market Programmeespecially the single license provision of the Second Banking Co-ordination Directive of 1989 essentially allowed banking organizations to expand continent-wide. In Latin America, the transition nations of Eastern Europe, and other regions, explicit and implicit regulatory barriers to foreign entry have fallen, allowing banking organizations headquartered in other nations to gain signicant market shares. The role of technological progress in facilitating geographic expansion is less well understood. In any industry, there are potential diseconomies to geographic expansion in the form of agency costs associated with monitoring junior managers in a distant locale. Improvements in information processing and telecommunications may lessen these agency costs by improving the ability of senior managers located at the organizations headquarters to monitor and communicate with staff at distant subsidiaries. In the banking industry, technologies such as ATM networks and transactional Internet websites allow banks to interact efciently with customers over long distances. Advances in nancial technologies also facilitate long-distance interfaces with customers. Greater use of quantitative methods in applied nance, such as credit scoring, may allow banks to extend credit without geographic proximity to the borrower by hardening their credit information (Stein 2002). Similarly, the new products of nancial engineering, such as derivative contracts, may allow banks to unbundle, repackage, or hedge risks at low cost without respect to the distance from the counterparty. These nancial innovations may allow senior managers to monitor decisions made by loan ofcers and managers at distant afliate banks more easily, and evaluate and manage the contributions of individual afliate banks to the organizations overall returns and risk more efciently. In this study, we examine data on commercial banks in U.S. MBHCs over 198598, and test whether these data are consistent with some predictions about the effects of technological progress. We assess changes over time in the ability of managers at the lead or parent bank in the MBHC to control the performance of their nonlead afliates, as well as changes over time in the agency costs associated with the distance between the parents and afliates. While previous studies have examined these managerial control and geographic distance phenomena on a crosssectional basis, this study breaks new ground by testing whether technological innovation over time has improved the ability of banking companies to control their operations and/or mitigate the agency costs associated with distance. We study U.S. MBHCs over 1985-98 because the lions share of geographic expansion by U.S. banks during this time period used the MBHC framework and because these organizations signicantly increased their use of new information processing, telecommunications, and nancial technologies over this interval.
ALLEN N. BERGER AND ROBERT DEYOUNG
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We dene control as the ability of the organizations senior managers to export their managerial skills, policies, and procedures to their afliate banks. Since we cannot directly observe how banks are managed, we proxy for control by measuring the extent to which the efciency rank of a nonlead bank afliate varies with the efciency rank of the lead bank in the same MBHC. Efciency ranks are described in detail below. We measure the control derivative NONLEADRANK LEADRANKt, where NONLEADRANK is the efciency rank of a nonlead bank afliate in a MBHC, LEADRANK is the efciency rank of the lead bank in the same MBHC, and |t indicates evaluation at period t. This derivative is expected to be positive and to lie between 0 (no control) and 1 (very good control). We estimate the control derivative in a multiple regression framework, and it represents the average degree to which multibank organizations in year t are able to control their afliates. Our hypothesis that technological progress has improved the control of banking organizations yields the prediction that NONLEADRANKLEADRANKt should be increasing with t. Our maintained assumptions are that the senior managers of the organization are located at the lead bank (the largest bank in the MBHC) and that LEADRANK is a good proxy for the skills, policies, and procedures available to manage the entire organization. Importantly, both well-managed and poorly managed organizations can have a high degree of control. Efcient senior managers with substantial control may transfer best-practices techniques to junior managers at their afliate banks, whereas inefcient senior managers with signicant control may transfer worst practices to afliates. We dene agency costs of distance as the additional expenses or lost revenues that arise as senior managers try to monitor and control local managers from a greater distance. The general effect of these agency costs is expected to be negative, as local managers operating at greater distance have more freedom to pursue their own objectives, resulting in lower efciency ranks. These agency costs may also incorporate a potentially offsetting senior management effect: operating at a greater distance from very inefcient senior managers may enhance efciency if it interferes with the transfer of worst practices. Thus, the agency costs of distance may depend on the efciency of senior management, with more costs involved with increased distance from good senior management and less costs, or even gains in afliate efciency, associated with increased distance from bad senior management. Since we cannot directly observe agency costs, we proxy (inversely) for the agency costs of distance by measuring the extent to which the efciency ranks of nonlead afliate banks vary with the distance from their lead banks. We measure the distance derivative NONLEADRANKlnDISTANCEt ,where lnDISTANCE is the natural log of the distance in miles between the afliate bank and its lead bank. For any value of t, this derivative is expected to be negative for most banks, as greater distance implies more problems in aligning the incentives of local managers with those of the organization. However, when senior management is very inefcient, the senior management effect may overwhelm the general agency cost effect, yielding a net positive distance derivative. We investigate this possibility
below. The distance derivative is estimated in the same multiple regression framework as the control derivative. Our hypothesis that technological progress has reduced the agency costs of distance yields the general prediction that NONLEADRANKlnDISTANCEt, should be increasing with t. We acknowledge that factors other than technological change also affect the control of parent organizations and the agency costs of distance. For this reason, we include variables in our empirical analysis to account for changes in competition, regulation, and other environmental conditions that may potentially inuence parental control and the agency costs of distance, and we conduct numerous tests to ensure that our results are not explained by sample selection bias, specication choices, bank size class effects, choice of time period, and so forth. Moreover, as in almost all studies of technological progress, it is difcult to deterministically link performance improvements to technological change because technology is difcult to specify, its effects are difcult to parameterize, and its adoption may in some cases be endogenous to rm and industry performance. Nonetheless, previous research suggests that banking rms are one of the best places to test for the effects of technological improvement. Banks have embraced substantial advances in both physical and nancial technologies during the past two decades, and the broader industry category of which banking is a part, Depository and Nondepository Financial Institutions, is the most information technology-intensive industry in the United States (Triplett and Bosworth 2002, Table 2). As well, when specic banking technologies have been studied, such as improvements in the processing of electronic payments, very large productivity gains have been directly linked to technological changes (e.g., Hancock, Humphrey, and Wilcox 1999).1 1. REVIEW OF RELATED RESEARCH LITERATURE To our knowledge, no prior studies have directly examined whether and by how much technological change over time has improved the ability of senior bank managers to control the performance of their afliates, branches, or other business units. As well, we are unaware of previous research investigating whether and by how much technological advances have reduced the agency costs associated with the distance from these geographically remote units. However, there are prior studies of related topics, including the degree to which bank productivity has improved over time, the degree to which bank-borrower distance has increased over time, the effects of organizational form on bank performance, and the cross-sectional effects of control and distance on bank efciency. We briey review some of this related research. Because the banking industry is relatively information-intensive, it may have been among the rst industries to take meaningful advantage of the benets of information processing and telecommunicationstechnological advances that could improve parental control over their afliate banks and reduce the agency costs of
1. See Berger (2003) for a general review of technological progress in banking.
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distance. Data from the Bureau of Labor and Statistics, which are based on a simple weighted measure of transactions per employee hour, are consistent with this possibility (Furlong 2001). Studies using cost productivity or linear programming methods to measure productivity for U.S. banks in the 1990s often found either productivity declines or only very slight improvements (e.g., Wheelock and Wilson, 1999, Stiroh, 2000, Berger and Mester, 2003). However, the latter of these studies found increasing prot productivity even while cost productivity declined, suggesting substantial revenue-based productivity improvements. This nding suggests that technological progress made banks more prot efcient by allowing them to offer a wider array of costlier, but higher quality services that generated increased revenues in excess of the higher costs.2 Recent research has also found that banks have been increasing the distances at which they make small business loans over time (e.g., Petersen and Rajan, 2002, Hannan, 2003) and that this trend has been facilitated in part by the adoption of the small business credit scoring technology, which is associated with increased out-of-market lending (Frame, Padhi, and Woosley 2004). These ndings are consistent with the hypothesis that technology may have increased parental control and reduced the agency costs of distance by making it easier to monitor loan ofcers and other personnel at greater distances. Of course, these ndings may have other causes as well. For example, one study found a link between the increased integration of state and regional economies and the geographic expansion of banks (Morgan, Rime, and Strahan 2003), suggesting that a more geographically integrated economy eases the management tasks of MBHCs. Other distance-related research has found that expanded geographic reach has had generally favorable effects on bank performance. Some studies found that larger, more geographically integrated institutions tend to have better risk-expected return frontiers (e.g., Hughes, Lang, Mester, and Moon, 1996, Demsetz and Strahan, 1997).3 Others found that banking organization mergers and acquisitions (M&As) raise prot efciency in a way consistent with the benets of improved geographic diversication, although M&As may not have much effect on cost efciency (e.g., Akhavein, Berger, and Humphrey, 1997, Berger, 1998). These studies generally found that the pre-merger gap in efciency between the acquirer and target had relatively little effect on the change in efciency surrounding the M&A, suggesting that the ability of acquirers to export their skills, policies, and procedures to targets may be limited. In contrast, studies of international banking expansion tend to nd that foreign afliates operate less efciently than domestic banks in developed nations, particularly in the United States (e.g., DeYoung and Nolle, 1996, Berger, DeYoung,
2. Studies using 1980s data often found productivity declines during the early part of the decade associated with adjustments to the deregulation of deposit rates (e.g., Berger and Humphrey 1992, Humphrey and Pulley 1997). Many of these studies also found that the industry had adjusted to the new regime by the late 1980s. 3. A study of simulated mergers among small U.S. banks suggested that such mergers may also generate risk reductions, but that the key risk-reducing benets for these banks stem from increased size, not greater geographic integration (Emmons, Gilbert, and Yeager 2004).
Genay, and Udell, 2000), although cross-border expansion may involve many other costs due to social, economic, and legal differences across countries. A number of cross-sectional studies examined the effects of organizational form and ownership on bank efciency, with mixed results. Some have found that afliate banks in MBHCs are more efcient than nonafliated independent banks (e.g., Spong, Sullivan, and DeYoung, 1995, Mester, 1996), while others have found that MBHCs are less efcient (e.g., Grabowski, Rangan, and Rezvanian 1993). Studies of the efciency of individual branches of large branch-banking organizations found signicant dispersion, consistent with relatively weak organizational control over individual branches (e.g., Sherman and Ladino, 1995, Berger, Leusner, and Mingo, 1997). Finally, a study of banking ofces in Texas nds that rural banking ofces are more likely than urban banking ofces to be locally owned; the authors conclude that the activities in which rural banks engage are more difcult to manage from a distance and hence require decision-making authority at the local level (Brickley, Linck, and Smith 2003). To our knowledge, only two previous studies have directly explored the concepts of control and agency costs of distance in banking. A study of 715 commercial bank afliates in ve U.S. states in 1973 and 1974 found that the ability of MBHCs to control the performance of their afliates varies both across MBHCs and across afliates within MBHCs (Rose and Scott 1984). A more recent crosssectional analysis of U.S. banks over 1993-98 found that parent organizations exercise signicant control over the efciency of their afliates, although this control tends to dissipate rapidly with the distance to the afliate (Berger and DeYoung 2001). These studies were purely cross-sectional in nature, and hence did not test for intertemporal changes in control or agency costs of distance. The current study extends this literature by testing whether the ability of banking companies to control their afliates has improved over time, presumably due to access to new information processing, telecommunications, and nancial technologies. We perform these tests for U.S. commercial bank holding companies from 1985 to 1998, a period during which (1) most large banking companies were still organized as MBHCs with afliates located at various distances from headquarters, and (2) the implementation of new technologies potentially provided senior managers with better tools for controlling the behavior of those afliates. Thus, we test not only whether technological progress has enhanced the potential for managerial control, but also whether technological advances have mitigated the agency costs of distance. Neither of these questions has been tested in the extant literature. 2. METHODOLOGY AND DATA We test for intertemporal changes in parental control and the agency costs of distance by analyzing the effects of lead bank efciency rank and distance to the lead bank on the efciency ranks of nonlead banks in U.S. MBHCs between 1985 and 1998. The U.S. data over this 14-year period provide an excellent opportunity
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for analyzing technological change, parental control, and distance effects. The U.S. market is economically large and geographically vast, and for most of this time period U.S. banking companies were generally required to use the MBHC framework to operate in multiple states. Because this organizational framework requires each afliate to prepare a complete set of nancial statements, we can observe the performance of each afliate bank (lead and nonlead) separately, which allows us to estimate and test the changes in our control and distance derivatives. Obtaining clear measures of efciency, parental control, geographic distance, and agency costs of distance are essential to our ultimate objective, which is to test whether technological progress has signicantly affected the ability of banking companies to control their operations and/or mitigate the agency costs associated with distance. We run our analyses separately by size of bank because of the different products, markets, and technologies for large and small banks. Large banks tend to produce more transactions-driven loans for large, wholesale customers based on hard quantitative information, such as certied audited nancial statements. In contrast, small banks tend to specialize in relationship lending to small, retail customers based on soft information culled from close contacts over time of the loan ofcer with the rm, its owner, and its local community (e.g., Stein, 2002, Berger, Miller, Petersen, Rajan, and Stein, 2005). Technological progress may affect the control and distance derivatives differently for large and small banks. Advances in information processing, telecommunications, and nancial technologies are likely to be better adapted to processing, transmitting, and analyzing the hard information used by large banks than the soft information used by small banks, so there may be a greater increase over time in the control of large nonlead afliates. The newer technologies often allow for the electronic transmission of hard information with little or no effect of distance, which may also result in a larger increase in control and a greater reduction in agency costs associated with longer distances for large banks. However, any of these effects could alternatively be greater for small afliates than for large afliates. It is possible that the technological improvements during the sample period may have allowed MBHCs to apply some of the hard-information techniques to small bank afliates for the rst time, in effect hardening their credit information. Thus, there may be a greater increase in control and/or a larger reduction in agency costs of distance over time for small bank afliates than for large afliates as MBHCs bring small business credit scoring and other hard-information techniques to small afliates. For these reasons, we separate the nonlead banks in MBHCs into two samples based on size. Our main sample includes annual observations of nonlead banks with gross total assets (GTA) in excess of $100 million (real 1998 dollars) in that year, and our small bank sample includes observations of nonlead banks in which GTA is less than or equal to $100 million (real 1998 dollars). We exclude from both samples all observations of banks that are less than 5 years old because prior
research found that very young banks do not approach the efciency of older small banks for several years.4 As noted above, we assume that LEADRANK is a good measure of the managerial ability of the senior staff of the MBHC and that these senior managers are located at the lead bank. The rst assumption allows us to interpret NONLEADRANK/ LEADRANK as a good proxy for control or how closely the performance of nonlead managers conform to the performance of their senior managers at the lead bank. The second assumption allows us to interpret NONLEADRANK/lnDISTANCE as a good proxy for the agency costs of distance, or the losses due to the extra difculties of senior managers in monitoring or controlling the performance of local managers from a greater distance. We believe these assumptions to be reasonable the senior management of large MBHCs also usually directly manages the largest bank in the organization. 2.1 Regression Specication and Tests Our analysis is primarily based on panel regressions of the efciency rank of nonlead banks in MBHCs (NONLEADRANK) on the efciency rank of the lead bank (LEADRANK) and the log of the distance to the lead bank (lnDISTANCE). We allow the control and distance effects to vary over time by including a time variable (t) in these regressions. A number of additional exogenous variables are included to account for other factors that may affect the efciency of the nonlead bank. These regressions take the form: NONLEADRANKit 1*LEADRANKit 2*lnDISTANCEit 3*LEADRANKit*lnDISTANCEit 1*t 1/22*t2 1*t*LEADRANKit 2*t*lnDISTANCEit 3*t*LEADRANKit*lnDISTANCEit 1/21*t2*LEADRANKit 1/22*t2*lnDISTANCEit 1/23*t2*LEADRANKit*lnDISTANCEit 4*MSAit 5*HERFit 6*lnBKASSit 7*1/2lnBKASS2 it 8*lnHCASSit 9*1/2lnHCASS2 it 10*BKMERGEit 11*HCMERGEit 12*MNPLit 13*NUMAFFSit 14*1/2NUMAFFS2 it 15*UNITBit 16*LIMITBit 17*INTERSTATEit 18*ACCESSit 19-68*STATE DUMMIESi it ,
4. DeYoung and Hasan (1998) found that the average new bank chartered between 1980 and 1994 needed nine years to become as prot efcient as the average mature small bank, although most of this performance shortfall had been erased by the fth year. DeYoung (2003) found that de novo banks chartered after 1994 tended to mature more quickly than those from the pre-1994 period.
(1)
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where i indexes the nonlead afliate bank and t indexes the time period, t 1,...,14 for the years 1985-98. We use OLS to estimate Equation (1) separately and independently for the main sample and the small bank sample. Within each of these samples, we also estimate Equation (1) for all of the observations and for a subset that includes only survivor banks that continued to exist through the end of the sample period. The key variables in Equation (1) are NONLEADRANK, LEADRANK, and lnDISTANCE. NONLEADRANK is the prot efciency rank of the nonlead bank afliate. LEADRANK is the prot efciency rank of the lead bank, dened as the largest bank in the MBHC. lnDISTANCE is the natural log of the distance in miles as the crow ies between the cities or towns in which the lead and nonlead banks are located (one mile added to DISTANCE before logging). The natural log form of lnDISTANCE allows for the likelihood that the travel time or cost per mile is decreasing in distance, i.e., time and cost economies of scale in distance. The database from which the distances are calculated matches the latitude and longitude over more than 19,000 different U.S. locations, nearly all cities, towns, and counties with over 5000 inhabitants.5 We include the interaction term LEADRANK*lnDISTANCE in Equation (1) to account for the likelihood that parental control diminishes with distance or that the agency costs of distance may be greater when the lead bank is more efciently managed (the senior management effect discussed above). We use a quadratic specication for the time variable t, specifying both t and 1/2t2, and we interact both of these terms with the other important regressors, LEADRANK, lnDISTANCE, and LEADRANK*lnDISTANCE. This specication smoothes out year-to-year uctuations in the control derivative and the distance derivative over time, and allows these derivatives to follow nonlinear time paths. We expect the control derivative to be positive for all values of t and to be between 0 (no control) and 1 (very good control). We test the following null hypothesis: NONLEADRANKLEADRANKtmean 1 3*lnDISTANCE (1 3*lnDISTANCE)*t (1/21 1/23*lnDISTANCE)*t2 0 , (2) where Equation (2) is evaluated for different values of lnDISTANCE. Once again we note that prot efciency and parental control are independent concepts: efcient senior managers with substantial control may transfer best practices to junior managers at their afliates, while inefcient senior managers with substantial control may transfer worst practices to afliate banks. Our hypothesis that technological progress has improved the control of banking organizations predicts that NONLEADRANKLEADRANKt should be increasing over time for any given value of distance. We test the null hypothesis of no change in parental control over time in two different ways. First, we test the difference in the control derivative between t 14 and t 1 (i.e., between 1998 and 1985):
5. We deleted a small number of observations for which the location could not be determined. We were able to match the location of over 99% of the lead banks and more than 98% of the nonlead banks.
NONLEADRANKLEADRANKt14 NONLEADRANKLEADRANKt1 (1 3*lnDISTANCE)*(14 1) (1/21 1/23*lnDISTANCE)*(142 12) 0 , (3) where Equation (3) is evaluated at the mean value of lnDISTANCE over the entire time period. This procedure avoids confounding the measured effects of control for a given distance with the effects of changes in distance over time. Second, we test whether the control derivative is increasing in t at the mean of the data, using the following second derivative: 2NONLEADRANKLEADRANKttmean (1 3*lnDISTANCE) 2*(1/21 1/23*lnDISTANCE)*t 0 . (4) The distance derivative is an inverse measure of the agency costs of distance. We expect the distance derivative to be negative in general for any value of t (i.e., positive agency costs). However, as discussed above, this derivative may be positive for very low levels of LEADRANK due to the potentially offsetting senior management effect. We test the following null hypothesis: NONLEADRANKlnDISTANCEtmean 2 3*LEADRANK (2 3*LEADRANK)*t (1/22 1/23* LEADRANK)*t2 0 , (5) where Equation (5) is evaluated for various values of LEADRANK. Our hypothesis that technological progress has reduced the agency costs of distance predicts that NONLEADRANK/lnDISTANCE should be increasing over time for any given value of lead bank efciency. We test the null hypothesis of no change in the agency cost of distance in two different ways. First, we test the difference in the distance derivative between t 14 and t 1: NONLEADRANKlnDISTANCEt14 NONLEADRANKlnDISTANCEt1 (2 3*LEADRANK)*(14 1) (1/22 1/23*LEADRANK)*(142 12) 0 , (6) where Equation (6) is evaluated at the mean value of LEADRANK over the entire time period. Second, we test whether the distance derivative is decreasing in absolute value with t at the means of the data, using the following second derivative: 2NONLEADRANKlnDISTANCEttmean (2 3*LEADRANK) 2*(1/22 1/23* LEADRANK)*t 0 . (7) To conserve degrees of freedom, only LEADRANK and lnDISTANCE are interacted with t in Equation (1). Hence, the coefcients on the remaining exogenous
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variables may be interpreted as the average effect of each variable over time. The market structure variables MSA and HERF are included to account for differences in competition, demand, and other market conditions that may affect bank performance. The variables lnBKASS and lnHCASS are included to account for the inuences of bank size and holding company size on afliate bank efciency. The merger dummy variables BKMERGE and HCMERGE are included to help account for short-term changes in bank performance associated with the consolidation process. The market nonperforming loans-to-total loans ratio MNPL is intended to capture the local economic conditions that are most relevant to bank performance. The variable NUMAFFS is included to account for potential economies or diseconomies of scale in managing nonlead banks. NUMAFFS, lnBKASS, and lnHCASS are included as both rst- and second-order terms in Equation (1) to allow for nonlinear scale effects. The regulatory dummy variables UNITB, LIMITB, INTERSTATE, and ACCESS attempt to capture the changes in state-by-state restrictions on geographic expansion at various times during the sample period. The vector STATE DUMMIES (counting the District of Columbia as a state, and excluding California as the base case) helps account for additional differences in conditions across states. Denitions and summary statistics for all of the variables (except STATE DUMMIES) are included in Table 1. Estimation of Equation (1) raises some econometric issues. First, the dependent variable NONLEADRANK and the independent variable LEADRANK are generated using OLS techniques (described in detail below). The inclusion of a generated regressor among the explanatory variables can in some circumstances affect the reported standard errors; however, Pagan (1984) demonstrates that the coefcient standard errors are consistent when the generated regressor is a residual from a least squares regression, which is the case here with LEADRANK. The additional noise in the generated dependent variable NONLEADRANK increases the regression standard error, but does not bias the estimated coefcients. Second, merger and acquisition activity increased during our sample period, which may affect our measured control and distance derivatives for reasons unrelated to technological progress. For example, control may have improved over time if nonlead banks that were poorly controlled early in the sample period were merged with bettercontrolled afliates or with the lead bank later in the sample period. Similarly, the agency costs of distance may have decreased over time because the banks that were the hardest to control at a given distance were merged out of existence. We address this issue by estimating Equation (1) for both the full data set and a survivor data set that includes only nonlead banks that survived through 1998 (regardless of when they entered the data set and regardless of whether they were still nonlead banks in MBHCs in 1998). Third, a maintained assumption is that the geographic distribution of nonlead afliate banks is exogenous and is not inuenced by the absolute or relative levels of lead and nonlead bank efciency. We recognize that this is an abstraction: at the
TABLE 1
Definitions and Summary Statistics for Variables in Equation (1)

Main sample Full Data Set (N 13411) Mean Std. Dev. Mean Std. Dev. Mean Std. Dev. Survivor Data Set (N 4363) Full Data Set (N 17499) Small bank sample Survivor Data Set (N 7948) Mean Std. Dev.
Variable denition
0.607 0.439 238.92 4.576 6.940 866,264 12.703 22,587,297 15.975 0.732 0.184 0.116 0.189 1.516 0.443 15.638 0.692 1.104 36,069,278 12.750 21,903,028 1.190 45,581,663 1.628 0.462 0.108 1.505 3.859 3,109,132 4.601 9.360 1,078,035 1.433 3.798 4,609,004 3.822 6.971 46,534 10.578 3,688,328 13.284 0.380 0.244 377.36 241.65 398.21 99.55 0.301 0.416 0.303 0.5206
0.296
0.599
0.288
0.613
0.278 0.283 181.37 1.305 3.866 24,603 0.627 10,792,546 1.824 0.485 0.171
0.595 0.542 84.03 3.757 8.780 43,656 10.503 1,630,531 12.592 0.311 0.253
0.270 0.274 160.34 1.168 3.811 24,219 0.643 8,905,602 1.476 0.463 0.167
NONLEADRANK Prot efciency rank of nonlead banks in MBHCs. LEADRANK Prot efciency rank of lead bank (largest bank in the MBHC). DISTANCE Distance in miles between nonlead bank and lead bank. lnDISTANCE Natural log of (DISTANCE1). t Time variable in years starting in 1985. BKASS Gross total assets of nonlead afliate bank (thousands of 1998 dollars). lnBKASS Natural log of BKASS. HCASS Sum of gross total assets for all banks in MBHC (thousands of 1998 dollars). lnHCASS Natural log of HCASS. MSA 1 if nonlead bank is in a Metropolitan Statistical Area (MSA). HERF Average Herndahl index, weighted by share of nonlead deposits in each MSA or non-MSA county in which it operates.
(Continued)
TABLE 1
Continued
Main sample Full Data Set (N 13411) Mean Std. Dev. Mean Std. Dev. Mean Std. Dev. Survivor Data Set (N 4363) Full Data Set (N 17499) Small bank sample Survivor Data Set (N 7948) Mean Std. Dev.
Variable denition
0.022
0.012
0.019
0.011
0.021
0.014
0.018
0.012
0.196 0.296 20.620 0.101 0.437 0.812 0.342 0.308 0.453 0.302 0.496 0.391 0.029 0.389 0.922 0.169 0.488 0.268 0.325 19.425 17.148 16.451 0.456 0.238 0.426
0.397
0.212
0.409
0.023 0.344 10.162 0.151 0.545 0.742 0.300
0.149 0.475 14.652 0.358 0.498 0.438 0.312
0.022 0.318 5.406 0.069 0.536 0.863 0.388
0.147 0.466 8.801 0.254 0.499 0.344 0.333
MNPL Average market nonperforming loan ratio, weighted by share of nonlead deposits in each MSA or non-MSA county in which it operates. BKMERGE 1 if afliate in merger in prior three years. HCMERGE 1 if changed high holding company afliation in the prior three years. NUMAFFS Number of afliates under the same high holder. UNITB 1 if unit banking state. LIMITB 1 if limited branching state. INTERSTATE 1 if interstate bank holding company expansion is allowed. ACCESS Percent U.S. banking assets in states with access to nonlead banks state.
Notes: The data are annual observations for nonlead banks in MBHCs for the years 1985-98. The lead bank is dened as the largest banking afliate in the MBHC, and a nonlead bank is any commercial banking afliate in an MBHC other than the lead bank. The Main Sample includes annual observations of nonlead banks with gross total assets (GTA) in excess of $100 million, whereas the Small Bank Sample includes observations in which GTA is less than or equal to $100 million (real 1998 dollars). The Full Data Sets include all observations, while the Survivor Data Sets include only nonlead banks that survived through 1998. Data are from the U.S. commercial bank Call Reports, the FDIC Summary of Deposits, and authors calculations.
margin, well-run organizations may be more likely than average to acquire and manage afliate banks located far from headquarters. To the extent that this effect is present in our data, then our estimated distance derivatives (Equation 5) will understate the agency costs of distance because longer distances will tend to be found in organizations that are better able to manage distance-related costs. Hence, nding a negative sign for the distance derivative is a strong result, as it indicates that the agency costs of distance more than offset the managerial efciency effect. Similarly, the distribution of nonlead afliate banks within an MBHC may be endogenous to past acquisition patternsfor example, if inefcient MBHCs systematically acquired more efcient afliates in order to import managerial talent and best practices. To the extent that this phenomenon is present in our data, then MBHCs with inefcient lead banks would contain a mix of relatively inefcient nonlead banks (i.e., the original afliates) and relatively efcient nonlead banks (i.e., the newly acquired afliates), causing a dispersion in NONLEADRANK away from LEADRANK that would bias our estimated control derivative (Equation 2) toward zero. Hence, nding a positive sign for the control derivative is a strong result. Because we cannot directly observe the implementation of new technologies at banks and bank holding companies, we must rely on the time variable t as a proxy for technological progress. As stated above, this is common practice in the empirical microeconomic and macroeconomic literatures. We acknowledge that this is an imperfect measure because it pools technological advance with other intertemporal changes in conditions faced by banks. For this reason our right-hand-side specication of Equation (1) includes a number of variables that control for other important environmental changes over time, including state and interstate regulatory restrictions (UNITB, LIMITB, INTERSTATE, ACCESS), local competitive conditions (HERF), and local economic conditions (MNPL). In addition, we also check the robustness of our results by estimating Equation (1) and the derivatives (Equations 27) for sub-periods of our 1985-98 data set. 2.2 Summary Statistics The summary statistics displayed in Table 1 allow us to compare the banks in the main and small bank samples, as well as the banks in the full and survivor data sets. The survivor data sets have fewer than half as many observations as the full data sets because of the substantial consolidation of the banking industry. These consolidation effects may have an especially large impact on nonlead banks in MBHCs, as these nonlead banks were especially prone to disappear over time as geographic deregulation allowed MBHCs to combine afliates at greater distances. Consistent with the consolidation, the mean value of t is around 9 for the survivor data sets versus around 7 for the full data sets, as the survivor data sets exclude more of the early observations. Note that average bank efciency is about the same in the survivor data sets and the full data setsthis reects the fact that we are measuring efciency using ranks rather than levels. Most of the comparisons between the main and small bank samples yield the expected ndings. Compared to the nonlead banks in the main sample, the small
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nonlead banks tend to be (1) located much closer to their lead bank, (2) in more highly concentrated rural markets, and (3) in much smaller MBHCs with fewer total afliates. The average efciency across the two samples is very similar because the efciency ranks are measured only against other banks in the same size grouping (above or below $100 million in GTA). Finally, the nonlead afliates have higher cost and prot efciency ranks on average than the lead banks in both the main sample and the small bank sample. This could reect a number of different factors. Back-ofce operations and headquarters functions such as payroll processing, marketing, and legal support may not be fully accounted for in intra-organizational accounting (e.g., incorrect or incomplete transfer pricing), resulting in nancial statement subsidies owing from lead banks to nonlead afliates. In addition, it is likely that our efciency model does not fully specify the wide scope of nancial products and services produced at large lead banks (e.g., private banking, proprietary mutual funds, merger nance, global services). Finally, the high mean efciency levels of nonlead banks relative to lead banks could simply be an arithmetic result of the fact that efcient banking organizations (i.e., high efciency ranks at both the lead and nonlead banks) tend to have relatively large numbers of afliates.6 We include a number of right-hand-side variables in our regression Equation (1) to try to mitigate these potential effects. Figure 1 shows how the average distance between nonlead afliates in MBHCs and their lead banks has evolved over time. For the main sample, the average distance increased by about 60%80% from 1985 to 1998, consistent with the geographic
Fig. 1. Distance in miles between lead banks and nonlead banks within MBHCs by year, 1985-98.
6. Berger and DeYoung (2001) found that the afliates of banking organizations with 10 or more afliates tend to exhibit above-average efciency.
deregulation of U.S. banking discussed above. In contrast, for the small bank sample, the increase in distance was only on the order of about 15%30%.7 As discussed above, the geographic expansion via acquisition of small bank afliates may have proceeded more slowly because small banks may be more difcult to control and subject to more agency costs of distance because of their specialization in local relationships based on soft information. For both samples, the average distance in the survivor data sets tends to be less than in the full data sets, a nding that is broadly consistent with our conjectures about the deleterious effects of distance on organizational management and control. 3. MEASURING BANK EFFICIENCY RANKS We base our analysis of lead and nonlead bank performance on the prot efciency concept, rather than the often-used cost efciency concept because prots are conceptually superior to costs for evaluating overall rm performance. The economic goal of prot maximization requires that the same amount of managerial attention be paid to raising a marginal dollar of revenue as to reducing a marginal dollar of costs. As well, if there are substantial unmeasured differences in the quality of services across banks and over timewhich is almost surely the casea bank that produces higher quality services should receive higher revenues that compensate it for at least some of its extra costs of producing that higher quality. Such a bank may be measured as less cost efcient because of the extra associated costs but will appropriately be measured as more prot efcient if its customers are willing to pay more than the extra costs in exchange for the higher quality. As discussed below, we also perform all the tests using cost efciency as a robustness check, with similar ndings. We start with a prot function at time t of the form:
ln(it t) ft(wit, yit, zit, vit) ln u it ln it ,
(8)
where is bank prot and t is a constant for year t that makes it t positive for all banks (so that the dependent variable expressed as a natural log is dened); i indexes banks ( 1, N); f denotes some functional form; w is the vector of variable input prices faced by the bank; y is the vector of its variable output quantities; z indicates the quantities of any xed netputs (inputs or outputs); v is a set of variables measuring the economic environment in the banks local market(s); ln u is a factor that represents a banks efciency; and ln is random error that incorporates both measurement error and luck. We estimate the prot function separately each year using OLS, treating (ln u ln ) as a composite error term. The prot efciency of bank i at time t is based on a comparison of its actual prots (adjusted for random error) to the maximum potential (best-practice) prots
7. The overall increase from 123.35 to 188.91 miles between 1985 and 1998 cited in the introduction is based on the weighted averages from the full data sets for the main and small bank data sets.
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it could attain given its output bundle and other exogenous variables (w, y, z, v). Assuming temporarily that we have an estimate of the efciency factor ln u it, the prot efciency of bank i at time t would be given by: PROFEFFit
{exp [ f (wit, yit, zit, vit)] exp [ln u it it]} maxt {exp [ f (wit, yti, zit, vit)] exp [ln u maxt]}
(9)
where u max t is the maximum u it across all banks in the sample. PROFEFF can be thought of as the proportion of a banks maximum prots that it actually earns.8 We take two additional steps to arrive at the estimates of the efciency ranks, NONLEADRANK and LEADRANK, that are used in our analysis of the changes over time in the control and distance derivatives. First, we use the residuals from OLS estimation of Equation (8) as estimates of the prot efciency factor ln u it. Second, we create a rank ordering of the banks in each year and peer group (main sample or small bank sample) based on those residuals. Prot efciency ranks measure how well a bank is predicted to perform relative to other banks in their main sample or small bank sample peer group for producing the same output bundle under the same exogenous conditions in the same year. These ranks are calculated on a uniform scale over [0, 1], using the formula (orderit 1)(nt 1), where orderit is the place in ascending order of the ith bank in the tth year in terms of its prot efciency and nt is the number of banks in the relevant sample in year t. Thus, bank is efciency rank in year t gives the proportion of the banks in its peer group in year t with lower efciency (e.g., a bank in year t with efciency better than 80% of its peer group has a rank of 0.80). The worst-practice bank in the relevant sample (lowest PROFEFF) has a rank of 0, and the best-practice bank (highest PROFEFF) has a rank of 1. We use efciency ranks, rather than efciency levels, because ranks are more comparable over time. The main purposes of this research are to test for intertemporal changes in parental control and the agency costs of distance on nonlead bank performance, which we proxy by changes in NONLEADRANK/LEADRANK and NONLEADRANK/lnDISTANCE over time. Efciency levels may change considerably over time with the interest rate cycle, real estate cycle, macroeconomic cycle, and changes in bank regulation. Thus, comparing efciency levels at different times might confound changes in the distribution of efciency with changes in parental control or with changes in the agency costs of distance. Using efciency ranksthat is, ranking banks within a uniform [0,1] distribution in each time periodgenerally neutralizes this problem by focusing on the relative order of the banks in the efciency distribution at a given time.
8. This is often called alternative prot efciency because we specify output quantities y, rather than output prices p, in the prot function. We use this concept primarily because output prices are difcult to measure accurately for commercial banks and because output quantities are relatively xed in the short run and cannot respond quickly to changing prices as is assumed in the standard prot efciency. Prior research generally found similar results for estimates of standard and alternative prot efciency (e.g., Berger and Mester 1997).
Our method is a special case of the distribution-free efciency measurement approach that uses a single residual instead of averaging residuals over a number of years. The single-residual method here is less accurate than the usual distributionfree approach, which averages out more random error by using more years of data. Our approach should also yield ranks that are very similar to those yielded by the stochastic frontier approach, an approach that is commonly used to estimate efciency in a single cross-section.9 We estimate the prot function using the Fourier-exible functional form, which has been shown to t the data for U.S. banks better than the more commonly specied translog form (e.g., Berger and DeYoung 1997). We specify three variable input prices (local market prices of purchased funds, core deposits, and labor); four variable outputs y (consumer loans, business loans, real estate loans, and securities); three xed netputs z (off-balance-sheet activity, physical capital, and nancial equity capital); and an environmental variable STNPL (ratio of total nonperforming loansto-total loans in the banks state). By using local market input prices, rather than the prices paid by each bank, the efciency ranks will reect how well individual banks price their inputs. We calculate efciency ranks using virtually all U.S. commercial banks for every year, 1985-98, although our regressions only include the efciency ranks of banks that are lead banks or nonlead afliates in MBHCs. The prot functions are always estimated separately for the main sample and the small bank sample because of the differences in products and markets discussed above. 4. EMPIRICAL RESULTS Table 2 displays the estimated parameters of regressions using 1985-98 U.S. banking data. Equation (1) is estimated four times: for the full and survivor data sets from the main sample (GTA $100 million in real 1998 dollars) and for the full and survivor data sets from the small bank sample (GTA $100 million in real 1998 dollars). The key exogenous variablesLEADRANK, lnDISTANCE, and tare all interacted, so no one coefcient on these variables can be easily interpreted by itself. We focus on the control and distance derivatives derived from the formulas shown in Equations (2)(7). To avoid confounding our estimates of parental control and agency costs of distance with the effects of changes in the exogenous variables over time, we evaluate the control and distance derivatives at the overall 1985-98 sample means for the exogenous variables (with the exception in some cases of the time variable t). 4.1 Control and Distance Derivatives The top panel in Table 3 shows the estimated control derivatives at the mean of t from Equation (2), NONLEADRANKLEADRANKtmean.When evaluated at
9. This is because the stochastic frontier approach also forms the expectation of the inefciency term ln uit based on the observed residual, and this ranking is in the same order as the residuals for any distributions imposed on ln u and ln .
TABLE 2
OLS Estimates from the NONLEADRANK Regressions for the Main Sample and Small Bank Sample
Main Sample Full Data Set (N 13411) Coefcient t-stat. Coefcient t-stat. Coefcient t-stat. Coefcient Survivor Data Set (N 4363) Full Data Set (N 17499) Small Bank Sample Survivor Data Set (N 7948) t-stat.
Intercept LEADRANK lnDISTANCE LEADRANK*lnDISTANCE t t*LEADRANK t*lnDISTANCE t*LEADRANK*lnDISTANCE 1/2 t2 1/2 t2 *LEADRANK 1/2 t2 *lnDISTANCE 1/2 t2 *LEADRANK*lnDISTANCE lnBKASS 1/2 lnBKASS2 lnHCASS 1/2 lnHCASS2 MSA HERF MNPL BKMERGE HCMERGE NUMAFFS 1/2 NUMAFFS2 UNITB LIMITB INTERSTATE ACCESS Adjusted R-Squared
1.262*** 0.048 0.036*** 0.029* 0.102*** 0.127*** 0.012*** 0.020*** 0.012*** 0.017*** 0.002*** 0.003*** 0.092** 0.005 0.015 0.001 0.011 0.176*** 1.881*** 0.028*** 0.031*** 0.007*** 0.000*** 0.156*** 0.006 0.087*** 0.041*** 0.243
3.87 0.60 4.76 1.72 7.97 4.93 4.68 3.70 6.72 4.78 4.14 3.78 2.17 1.63 0.47 0.66 1.58 6.73 8.46 4.58 5.92 14.46 11.17 11.50 0.81 8.53 2.86
1.893*** 0.185 0.052** 0.019 0.113*** 0.102* 0.013** 0.013 0.014*** 0.016** 0.001** 0.002* 0.108 0.008* 0.059 0.002 0.010 0.269*** 0.532 0.031*** 0.066*** 0.011*** 0.000*** 0.175*** 0.028* 0.094*** 0.002 0.284
3.76 0.82 2.36 0.40 4.19 1.85 2.22 1.11 4.23 2.48 2.19 1.75 1.58 1.68 1.17 0.74 0.92 5.63 1.26 3.08 7.00 11.65 8.78 6.12 1.90 4.47 0.10
1.585*** 0.257*** 0.036*** 0.029* 0.076*** 0.025 0.012*** 0.003 0.006*** 0.001 0.001** 0.000 0.286*** 0.024*** 0.106*** 0.010*** 0.011** 0.065*** 0.825*** 0.007 0.008** 0.010*** 0.000*** 0.084*** 0.002 0.046*** 0.001 0.173
3.73 4.00 4.54 1.86 6.25 1.15 3.94 0.49 3.44 0.20 2.13 0.03 3.44 2.99 5.46 7.05 2.13 4.42 5.04 0.54 1.98 16.43 10.53 8.87 0.23 6.01 0.07
1.757*** 0.117 0.058*** 0.031 0.075*** 0.062 0.015*** 0.017* 0.006** 0.003 0.001 0.001 0.269** 0.023** 0.172*** 0.016*** 0.021*** 0.037* 0.190 0.002 0.025*** 0.022*** 0.001*** 0.069*** 0.014 0.019 0.020 0.234
2.89 0.85 3.03 0.92 3.37 1.63 2.74 1.76 2.02 0.73 1.58 1.00 2.28 2.02 5.75 7.40 3.04 1.83 0.70 0.09 4.26 20.05 15.27 4.64 1.44 1.58 1.33
Note: Data sets are unbalanced panels, 1985-98. Superscripts ***, **, and * indicate signicant difference from zero at 1%, 5%, and 10% levels. Coefcients for state dummy variables not reported.
TABLE 3
Measured Values of the Control and Distance Derivatives

Mean 25th percentile 50th percentile 75th percentile
A. Control derivatives evaluated at values from the sample distribution of lnDISTANCE 0.235*** 0.282*** 0.237*** 0.264*** (19.30) (13.59) (22.20) (17.46) 0.271*** 0.313*** 0.272*** 0.312*** (19.42) (13.52) (22.49) (18.31) 0.231*** 0.281*** 0.236*** 0.265*** (18.98) (13.52) (22.16) (17.55) 0.195*** 0.249*** 0.197*** 0.210*** (14.17) (10.57) (15.75) (11.81)
Main sample, full data set Main sample, survivor data set Small bank sample, full data set Small bank sample, survivor data set
B. Distance derivatives evaluated at values from the sample distribution of LEADRANK 0.006** (2.16) 0.013*** (3.01) 0.002 (0.63) 0.006* (1.67) 0.007** (2.03) 0.002 (0.33) 0.010*** (3.12) 0.010** (2.08) 0.005* (1.91) 0.013*** (2.92) 0.003 (1.18) 0.008** (2.19) 0.018*** 0.024*** 0.013*** 0.022*** (5.09) (4.32) (4.20) (4.94)
Main sample, full data set Main sample, survivor data set Small bank sample, full data set Small bank sample, survivor data set
Notes: Panel A displays measured control derivatives at the mean of t (NONLEADRANKLEADRANKtmean) from Equation (2), evaluated and tested at the mean and the 25th, 50th, and 75th percentiles from the sample distribution of lnDISTANCE. For the main sample, full data set, these values are 4.58, 3.75, 4.67, and 5.49, respectively. The points of evaluation are similar for the other samples. Panel B displays measured distance derivatives at the mean of t (NONLEADRANKlnDISTANCEtmean) from Equation (5), evaluated and tested at the mean and the 25th, 50th, and 75th percentiles from the sample distribution of LEADRANK. For the main sample, full data set, these values are 0.44, 0.15, 0.42, and 0.71, respectively. The points of evaluation are similar for the other samples. The values in parentheses are t-statistics. Superscripts ***, **, and * indicate signicant difference from zero at 1%, 5%, and 10% levels.
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the mean of lnDISTANCE (rst column), all four of the control derivatives are positive and between 0 (no control) and 1 (very good control), as expected. All four are also all statistically signicantly different from 0 at the 1% level. The positive, statistically signicant control derivatives indicate that after accounting for other factorssuch as distance, local market economic conditions, bank and MBHC size, and state regulationslead bank efciency and nonlead bank performance are signicantly positively related. This suggests that senior managers at the lead banks are able to transfer their policies, practices, and procedures to management at their nonlead afliate banks to at least some degree. The magnitudes of these control derivatives are similar for the main and small bank samples, suggesting that, on average, afliate size is not an important determinant of the ability of headquarters managers to control the efciency of afliate banks. The control derivatives are materially larger for the survivor banks relative to the full data set, consistent with our expectations that MBHCs in which control was weak should be more likely to exit the industry via failure or takeover. In all cases, the derivatives appear to be economically signicant. For example, the control derivative of 0.235 in the rst cell of panel A indicates that a 10 percentage point increase in lead bank efciency rank would yield a predicted increase of 2.35 percentage points in the efciency ranks of each of its nonlead bank afliates. Evaluating the control derivative at the 25th, 50th, and 75th percentiles of the sample distribution of lnDISTANCE (last three columns) shows how the magnitude of lead bank control changes with distance. The results suggest that control diminishes with distance, as expected. For example, as shown in the top row of panel A for the main sample, full data set, the control derivative is 4.0 percentage points lower for nonlead afliates at the median distance or 50th percentile (0.231) than for afliates closer to headquarters at the at the 25th percentile of distance (0.271). Similarly, the control derivative falls by about another 3.6 percentage points for afliates that are even more remote at the 75th distance percentile (0.195). The bottom panel in Table 3 shows the estimated distance derivatives at the mean of t from Equation (5), NONLEADRANKlnDISTANCEtmean. When evaluated at the mean of LEADRANK (rst column), these derivatives are negative and statistically signicant in three of the four cases, consistent with our hypothesis that aligning the incentives of local managers with those of the organization generally becomes more difcult with distance, resulting in lower afliate bank efciency. Although these estimated distance derivatives are small in absolute magnitude, the effect of a change in distance can be substantial for a banking organization that expands over very large distances within the United States. For example, the distance derivative of 0.013 (main sample, survivor data set) indicates that a doubling of the distance between a nonlead bank and its headquarters from about 240 miles to about 480 miles would reduce the efciency rank of the nonlead bank by almost a full percentage point (0.013*ln 2). Much larger potential reductions of efciency rank would be predicted for cross-country acquisitions, although we caution against extrapolating too far from the dense part of the data sample.
The absolute magnitude of the distance derivative is smaller in the small bank sample, suggesting perhaps that agency problems in monitoring banks that rely more on soft information are less sensitive to the distance from headquarters. In addition, we nd that the negative effects of distance tend to be greater in surviving organizations and in organizations with more efcient lead banks. Notably, the distance derivative is positive and statistically signicant in three of four cases when evaluated at the 25th percentile for LEADRANK, consistent with the possibility raised above that for very inefcient senior management, the senior management effect may overwhelm the general agency cost effect. That is, it may on net be more efcient to be further away from such management to avoid the transfer of their inefcient practices. 4.2 Intertemporal Changes in the Control and Distance Derivatives The main focus of our research is on the changes over time in the control and distance derivatives. We hypothesize that these derivatives should increase with t as improvements in nancial and nonnancial technologies improved the control of banking organizations and reduced the agency costs of distances. We calculate each of these derivatives for each of the regressions in Table 2 and for all values of time t. The year-to-year estimates are plotted in Figures 25, and the data underlying these gures are displayed in panel A of Tables 4 and 5. Panel A of these tables displays tests (3) and (6), NONLEADRANKLEADRANKt14 NONLEADRANKLEADRANKt1 and NONLEADRANKlnDISTANCEt14 NONLEADRANKlnDISTANCEt1, which measure the change in the control
Fig. 2. Control derivatives (Equation 2) estimated for the full data set, evaluated at the means of the data and at all values of t, 1985-98.
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Fig. 3. Control derivatives (Equation 2) estimated for the survivor data set, evaluated at the means of the data and at all values of t, 1985-98.
and distance derivatives from the beginning to the end of the 1985-98 sample period. Panel C of these tables displays the cross-derivative tests (4) and (7), and 2NONLEADRANK 2NONLEADRANKLEADRANKttmean lnDISTANCEttmean, which measure the change in the control and distance
Fig. 4. Distance derivatives (Equation 5) estimated for the full data set, evaluated at the means of the data and at all values of t, 1985-98.
Fig. 5. Distance derivatives (Equation 5) estimated for the survivor data set, evaluated at the means of the data and at all values of t, 1985-98.
derivatives with respect to time at the means of the data. We view tests (3) and (6) as more important than the cross-derivative tests (4) and (7) because the (3) and (6) tests measure the effects over the entire time period, not just at the mean of the period.10 Panel D repeats tests (3) and (6) from panel B, evaluating them at the 25th, 25th, 50th, and 75th percentiles for lnDISTANCE for the change in control derivatives (Table 4) and the same percentiles for LEADRANK for the change in distance derivatives (Table 5). All four of the control derivatives mapped out in Figures 2 and 3 are generally increasing over time and are larger at the end of the sample period than at the beginning. The U- or inverted U-shapes of these time paths are dictated by our quadratic regression specication. The estimated time paths decrease somewhat at the end of the sample period for the main sample, which may also reect the large number of M&As made during this time period (see discussion below). We focus primarily on the change over the entire time period t 1 to 1 14shown in panel B of Table 4which indicate that all four of the control derivatives increased during the sample period, three of which were statistically signicant. Moreover, these improvements in parental control over time were economically signicantthe smallest increase was about 35%, from 0.233 to 0.314 (small bank sample, survivor data set) while the largest increase was about 89%, from 0.160 to 0.303 (small bank
10. We recognize that the derivatives (Equations 3 and 6) are based on tted regression values far from the means of the data for t (i.e., at t 1 and t 14). This reduces the precision of the estimated derivatives, which may make it relatively difcult to reject the null hypotheses in these tests.
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TABLE 4 The Measured Effects of Intertemporal Changes in the Control Derivative for the Full Data Set, the Survivor Data Set, the Main Sample, and the Small Bank Sample, for 198598 (t 1,...,14)
Bank Sample: Data set Main Full Main Survivor Small Bank Full Small Bank Survivor
A. Control derivative evaluated at the 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 0.118 0.148 0.173 0.195 0.212 0.226 0.235 0.240 0.241 0.238 0.231 0.220 0.205 0.186
means of the data and annual values of t 0.139 0.175 0.205 0.230 0.251 0.266 0.277 0.283 0.283 0.279 0.269 0.255 0.236 0.211 0.160 0.174 0.188 0.201 0.213 0.225 0.237 0.248 0.258 0.268 0.278 0.287 0.295 0.303 0.233 0.234 0.236 0.239 0.242 0.247 0.252 0.258 0.265 0.273 0.282 0.292 0.302 0.314
B. Change in the control derivative from 1985 to 1998 0.068** (2.49) 0.072 (1.43) 0.004 (0.95) 0.143*** (6.02) 0.080** (2.29)
C. Change in the control derivative with respect to t at the means of the data 0.008*** (3.46) 0.011*** (6.19) 0.007*** (2.61) D. Change in the control derivative from 1985 to 1998, evaluated at the 25th, 50th, and 75th percentiles of the sample distribution of lnDISTANCE 25 th percentile 50 th percentile 75 th percentile 0.063** (2.05) 0.068** (2.51) 0.073** (2.33) 0.027 (0.44) 0.074 (1.47) 0.121** (2.05) 0.167*** (5.87) 0.143*** (6.02) 0.116*** (4.34) 0.153*** (3.73) 0.082** (2.34) 0.001 (0.00)
Notes: Panel A shows annual estimated values of Equation (2), the control derivative, evaluated at the overall means of the data for all variables other than t. Panel B shows the estimated values for Equation (3), the change in the control derivative between t 1 and t 14, along with associated t-statistics. Panel C shows the estimated for Equation (4), the change in the control derivative with respect to t at the means of the data, along with associated t-statistics. Panel D shows the change in the control derivative with respect to t at the means of the data, evaluated at the 25th, 50th, and 75th percentiles of the sample distribution of lnDISTANCE. Superscripts ***, **, and * indicate signicant difference from zero at 1%, 5%, and 10% levels.
sample, full data set). Panel C of Table 4 shows similar results for the intertemporal change in the control derivatives evaluated at the mean value of time t. Overall, these data are strongly consistent with our hypothesis that technological progress has allowed banking organizations to exercise substantially more control over nonlead afliates over time. Notably, the measured increases in control in panels B and C are generally greater for small bank afliates than large bank afliates. Although an investigation of this difference is beyond the scope of this paper, this nding is consistent with the possibility raised above that technological progress may have allowed MBHCs to apply some of the hard-information techniques to small bank afliates for the rst time, yielding substantial increases in control over these afliates. The improvement in parental control over time was sensitive to the distance between the lead and nonlead banks, as shown by Equation (3) results in panel D
TABLE 5 The Measured Effects of Intertemporal Changes in the Distance Derivative for the Full Data Set, the Survivor Data Set, the Main Sample, and the Small Bank Sample, for 198598 (t 1,...,14)
Bank Sample: Data set Main Full Main Survivor Small Bank Full Small Bank Survivor
A. Distance derivative evaluated at the means of the data and annual values of t 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 0.020 0.017 0.014 0.011 0.009 0.007 0.006 0.004 0.003 0.003 0.002 0.002 0.002 0.002 0.018*** (3.18) 0.052 0.046 0.040 0.034 0.029 0.025 0.021 0.017 0.014 0.012 0.010 0.008 0.007 0.006 0.046*** (3.97) 0.042 0.033 0.025 0.018 0.011 0.006 0.001 0.002 0.005 0.007 0.008 0.008 0.007 0.006 0.035 0.030 0.025 0.021 0.017 0.013 0.010 0.008 0.006 0.004 0.003 0.002 0.001 0.001 0.034*** (3.99)
B. Change in the distance derivative from 1985 to 1998 0.047*** (8.82)
C. Change in the distance derivative with respect to t at the means of the data 0.002*** (3.55) 0.003*** (3.11) 0.004*** (10.01) 0.002*** (3.14) D. Change in the distance derivative from 1985 to 1998, evaluated at the 25th, 50th, and 75th percentiles of the sample distribution of LEADRANK 25 th percentile 50 th percentile 75 th percentile 0.016** (2.27) 0.017*** (3.18) 0.019** (2.49) 0.029** (2.04) 0.045*** (3.94) 0.061*** (3.63) 0.055*** (8.28) 0.047*** (8.57) 0.040*** (5.62) 0.057*** (5.90) 0.031*** (3.60) 0.010 (0.88)
Notes: Panel A shows annual estimated values of Equation (5), the distance derivative, evaluated at the overall means of the data for all variables other than t. Panel B shows the estimated values for Equation (3), the change in the distance derivative between t 1 and t 14, along with associated t-statistics. Panel C shows the estimated for Equation (4), the change in the distance derivative with respect to t at the means of the data, along with associated t-statistics. Panel D shows the change in the distance derivative with respect to t at the means of the data, evaluated at the 25th, 50th, and 75th percentiles of the sample distribution of LEADRANK. Superscripts ***, **, and * indicate signicant difference from zero at 1%, 5%, and 10% levels.
of Table 4. In the main sample, control improved the most for the relatively distant afliates, consistent with the possibility raised above that technological progress allowed a greater increase in control for longer distances for these banks because of the electronic transmission of hard information with little or no effect of distance. In the small bank sample, however, we nd that the control derivative improved more dramatically over time at the relatively nearby afliates. This is consistent with the possibility that for small afliates, control improvements from the export of hard-information technologies to small afliates may have occurred more frequently for afliates closer to MBHC headquarters. Turning to the effects of technological progress on the agency costs of distance, all four of the distance derivatives plotted in Figures 4 and 5 increased over time. Panels B and C of Table 5 indicate that the intertemporal changes in the distance
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derivatives were statistically signicant. These changes were also economically signicant. The increase in the distance derivative between 1985 and 1998 tends to center around 0.04, suggesting that a doubling of distance from the lead bank reduced the efciency rank of a nonlead bank by about 2.8 percentage points less at the end of the sample period than at the beginning of the sample period (0.04*ln2). These data are consistent with our hypothesis that technological progress has reduced the agency costs of distance, and the effects do not differ greatly for large and small nonlead banks. As noted above, this nding may also reect in part other causes, such as the increased integration of state and regional economies. The degree to which the distance derivative increased over time was somewhat sensitive to the efciency of the lead bank in the organization, as shown by Equation (6) results in panel D of Table 5. For banks in the main sample, the data suggest that efcient lead banks were able to reduce the agency costs of distance more for large nonlead bank afliates. This is consistent with the possibility that efcient lead banks that likely specialize in the use of hard-information technologies also excelled at reducing the agency costs of distance for large nonlead afliates that also likely specialize in these same technologies. In contrast, the data suggest that for the small bank sample, distance-related inefciencies declined more slowly over time for organizations with efcient lead banks. This is consistent with the possibility that efcient lead banks that specialize in hard-information technologies were not as able to reduce agency costs associated with distance to small nonlead banks that tend to use soft-information technologies. The intertemporal increases in the control and distance derivatives shown in Figures 25 occur mostly during the rst portion of the sample period. Although the shapes of these estimated time paths are constrained by our quadratic specication of time, these shapes suggest that improvements in parental control and reductions in the agency costs of distance may have been easier to achieve during the late 1980s than in the 1990s. A full investigation of this phenomenon is beyond the scope of this study, but we suggest two reasonable hypotheses that are consistent with the data. First, the mergers of the 1990s tended to be larger, more complex, and involve more distant target banks (see Figure 1, especially for the main sample), which may have posed more difcult managerial challenges than the mergers of the 1980s. Second, as discussed above, banking was one of the rst industries to take advantage of improvements in information processing and telecommunications, consistent with the measured productivity gains made by banks in the late 1980s. 4.3 Robustness Tests We performed a number of additional robustness checks that are not shown in the tables and gures. First, we performed all of the above tests using cost efciency ranks in place of prot efciency ranks, and obtained similar, but somewhat weaker results. This suggests that technological advances as implemented at banking companies has helped improve parental control over both expenses and revenues, and reduce the impact of distance-related agency costs on both expenses and revenues, although the improvements were generally more pronounced on the revenue side.
Second, we estimated the regressions using subperiods of the data1985-1991 (the rst half of the panel), 1992-98 (the second half of the panel), and 198596 (before full effect of Riegle-Neal Act). These regressions yielded qualitatively similar results to those from the overall 1985-98 time period. Third, we estimated the regressions using efciency levels rather than efciency ranks, and using linear distance rather than the natural log of distance. These regressions always produced theoretically correct signs for the control and distance derivatives, although the behavior of these derivatives across time was somewhat less robust. Finally, we replaced each panel regression with 14 annual cross-section regressions.11 This cross-sectional approach allows all of the estimated regression parameters to vary freely from year to year and does not force the control and distance derivatives to follow smooth parabolic paths over time, but this approach also reduces estimation efciency relative to our panel approach because of the fewer numbers of restrictions. Although some of the resulting derivatives exhibited substantial noise from year to year, the results were qualitatively similar to our panel regression results.
5. CONCLUSIONS In this paper, we test if the data on banks in U.S. MBHCs over 1985-98 are consistent with some hypotheses about the effects of technological progress on the ability of the banking industry to expand geographically. The empirical results are strongly consistent with the predictions of our hypothesis that technological progress has allowed banking organizations to exercise substantially more control over nonlead afliates over time. Specically, our estimates suggest that the inuence of a lead banks efciency rank on the efciency rank of its nonlead bank afliates is substantial, and this ability to control its afliates increased on the order of 50%100% over the sample period. Furthermore, our estimates suggest that senior managers improved their ability to control both the costs and the revenues of their nonlead afliates over the sample period. The data are also consistent with our hypothesis that technological progress has allowed banking organizations to reduce the agency costs that arise when nonlead afliate banks are located far away from headquarters. These improvements appear to be more substantial on the revenue side than on the cost side of banks income statements. The issue of whether technological progress is facilitating the geographic expansion of the banking industry has important implications. Currently, only a few organizations in the United States have come close to expanding nationwide; only one has approached the Riegle-Neal cap of 10% of national bank and thrift deposits in one organization; and some banking organizations have explicitly reduced their
11. These regressions repeat the Equation (1) specication with two exceptions: we exclude the variable t as it has no cross-sectional variation; and we exclude UNITB, LIMITB, INTERSTATE, and ACCESS as they do not vary for banks within a state in a given year, making them redundant to the STATE DUMMIES.
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geographic footprints. Similarly, very few banks have taken advantage of the opportunity for almost continent-wide banking in Europe under the Single Market Programme. Nonetheless, if technological progress improves parental control and reduces the agency costs of distance, and if future technological innovations continue to have these effects, then we might expect many more banks to take advantage of the economies these innovations create and increase their geographic expansions. Although the MBHC form is primarily a vestige of past geographic restrictions on U.S. banking, we believe our ndings are relevant for the future performance of banks in the United States and in other nations that use different organizational forms. That is, advances in information, telecommunications, and nancial technologies are likely to improve managerial control and/or reduce the agency costs of distance within domestic branching networks, at foreign bank subsidiaries, and at (domestic and foreign) nonbank afliates in qualitatively similar fashions to the effects found here. Although geographic expansions related to improved control and reduced agency costs of distance would be associated with improved efciency of the individual nancial organizations, they could raise other questions. Cross-border consolidation may increase the cost of coordinating the regulatory responses among various national authorities to the failures of large multinational banking organizations. For instance, in the EU, national central banks have lender-of-last-resort responsibilities, whereas the European Central Bank controls monetary policy. Similarly, the homecountry rule established in the EU by the Second Banking Directive provides that the chartering nation has primary supervisory responsibility for the bank, which may separate where the impact of nancial distress is felt and where the responsibility for handling the problems lie. In the United States, state-chartered banks can now branch into other states across the nation, although this likely does not create as many problems as in the EU, since state-chartered banks also have a primary federal supervisor and banking powers and regulations do not vary extensively across the states. There may also be concerns about the effects of geographic expansion on the supply of some types of locally oriented services, such as relationship credit for small businesses. Expansion may create large organizations with headquarters that are distant from potential relationship loan customers, and these organizations may have difculty transmitting soft relationship information through their communications channels, may be focused more on serving large corporate customers, or (in the case of international expansion) may be headquartered in very different banking environments. However, to some extent these effects may be offset by the use of credit scoring and other nancial technologies that may allow banks to lend at greater distances by hardening the credit information. LITERATURE CITED
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Berger, Allen N. (1998). The Efciency Effects of Bank Mergers and Acquisition: A Preliminary Look at the 1990s Data. In Bank Mergers & Acquisitions, edited by Y. Amihud and G. Miller, pp. 79111. Boston, MA: Kluwer Academic. Berger, Allen N. (2003). The Economic Effects of Technological Progress: Evidence from the Banking Industry. Journal of Money, Credit, and Banking 35, 141176. Berger, Allen N., and Robert DeYoung (1997). Problem Loans and Cost Efciency in Commercial Banks. Journal of Banking and Finance 21, 849870. Berger, Allen N., and Robert DeYoung (2001). The Effects of Geographic Expansion on Bank Efciency. Journal of Financial Services Research 19, 163184. Berger, Allen N., Robert DeYoung, Hesna Genay, and Gregory F. Udell (2000). Globalization of Financial Institutions: Evidence from Cross-Border Banking Performance. BrookingsWharton Papers on Financial Services 3, 23158. Berger, Allen N., and David B. Humphrey (1992). Measurement and Efciency Issues in Commercial Banking. In Measurement Issues In the Service Sectors, edited by Z. Griliches, pp. 245279. Chicago: National Bureau of Economic Research, University of Chicago Press. Berger, Allen N., John H. Leusner, and John J. Mingo (1997). The Efciency of Bank Branches. Journal of Monetary Economics 40, 141162. Berger, Allen N., and Loretta J. Mester (1997). Inside the Black Box: What Explains Differences in the Efciencies of Financial Institutions? Journal of Banking and Finance 21, 895947. Berger, Allen N., and Loretta J. Mester (2003). Explaining the Dramatic Changes in Performance of U.S. Banks: Technological Change, Deregulation, and Dynamic Changes in Competition. Journal of Financial Intermediation 12, 5795. Berger, Allen N., Nathan H. Miller, Mitchell A. Petersen, Raghuram G. Rajan, and Jeremy C. Stein (2005). Does Function Follow Organizational Form? Evidence From the Lending Practices of Large and Small Banks. Journal of Financial Economics 76, 237269. Brickley, James A., James S. Linck, and Clifford W. Smith (2003). Boundaries of the Firm: Evidence from the Banking Industry. Journal of Financial Economics 70, 351383. Demsetz, Rebecca S., and Philip E. Strahan (1997). Diversication, Size, and Risk at Bank Holding Companies. Journal of Money, Credit, and Banking 29, 30013. DeYoung, Robert (2003). The Failure of New Entrants in Commercial Banking Markets: A Split-Population Duration Analysis. Review of Financial Economics 12, 733. DeYoung, Robert, and Iftekhar Hasan (1998). The Performance of De Novo Commercial Banks: A Prot Efciency Approach. Journal of Banking and Finance 22, 565587. DeYoung, Robert, and Daniel E. Nolle (1996). Foreign-Owned Banks in the U.S.: Earning Market Share or Buying It? Journal of Money, Credit, and Banking 28, 622636. Emmons, William R., R. Alton Gilbert, and Timothy J. Yeager (2004). Reducing Risk at Community Banks: Does Size or Geographic Diversication Matter? Journal of Financial Services Research 25, 259281. Frame, W. Scott, Michael Padhi, and Lynn Woolsey (2004). Credit Scoring and the Availability of Small Business Credit in Low- and Moderate Income Areas. Financial Review 39, 3454. Furlong, Fred (2001). Productivity in Banking, Federal Reserve Bank of San Francisco, Economic Letter 2001-22, July 27. Grabowski, Richard, Nanda Rangan, and Rasoul Rezvanian (1993). Organizational Forms in Banking: An Empirical Investigation of Cost Efciency. Journal of Banking and Finance 17, 531538. Hannan, Timothy H. (2003). Changes in Non-local Lending to Small Business. Journal of Financial Services Research 24, 3146.
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ALLEN N.

BERGER ROBERT DEYOUNG

Technological Progress and the Geographic Expansion of the Banking Industry

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Definitions and Summary Statistics for Variables in Equation (1)

0.023 0.344 10.162 0.151 0.545 0.742 0.300

0.149 0.475 14.652 0.358 0.498 0.438 0.312

0.022 0.318 5.406 0.069 0.536 0.863 0.388

0.147 0.466 8.801 0.254 0.499 0.344 0.333

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Measured Values of the Control and Distance Derivatives

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B. Change in the distance derivative from 1985 to 1998 0.047*** (8.82)

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