Out-of-State Entry and the Cost Efficiency of Local Commercial Banks

Robert DeYoung

Office of the Comptroller of Currency

Iftekhar Hasan

New Jersey Institute of Technology

Bruce Kirchhoff

New Jersey Institute of Technology

Office of the Comptroller of the Currency

Economics Working Paper 97-7

April 1997

Abstract The Riegle-Neal Act allows commercial banks to operate with complete freedom

across state lines beginning in June 1997. In an attempt to gauge the impact that full interstate

banking will have on the industry, we examine bank performance data from states that passed

interstate banking laws prior to the Riegle-Neal Act. We estimate cost inefficiency for banks

that operated exclusively in local markets in 1992, then regress those estimates on the

intensity of out-of-state activity in those markets during that year. 

In the years immediately following the removal of barriers to out-of-state banks, we

find that increased entry is associated with increased inefficiency for local banks. However,

this appears to be a short-run phenomenon only -- in markets that have allowed out-of-state

entry for at least six years, we find that inefficiency declines in response to increased entry. 

On average, cost inefficiency at local banks declines by about 3 percent for each additional

year that banks face interstate competition.

What do our results portend for the performance of local banks under the Riegle-Neal

Act? Interstate competition is already well under way in many metropolitan markets because

of state-by-state reciprocal compacts. For local banks in these markets, Riegle-Neal will

likely enhance the forces of competition by expanding the number of potential entrants. In

markets for which Riegle-Neal marks the first introduction of interstate competition, our

results suggest that interstate competition will gradually deliver substantial gains in cost

efficiency over the course of the next decade.

 

The views expressed here are those of the authors, and do not necessarily reflect those of the Office of the

Comptroller of the Currency, the Department of the Treasury, or their staffs. The authors thank Jennifer Eccles,

Kurt Jesswein, Joe Mason, David Nebhut, and Jim Overdahl for reviewing earlier drafts; participants at seminars

at Tel Aviv University and Tilburg University for helpful comments; Maria Montano for research assistance; and

Pat Eggleston for editorial assistance. Please address any comments to Robert DeYoung, Bank Research

Division, Office of the Comptroller of the Currency, Washington, DC 20219. Phone: (202) 874-5427. E-mail: 

robert.deyoung@occ.treas.gov.

Additional copies of this paper, or other Economics Working Papers, can be obtained from the Communications

Division, Office of the Comptroller of the Currency, 250 E Street, SW, Washington, DC, 20219. Telephone:

202-874-5043. E-mail: kevin.satterfield@occ.treas.gov.
 The Riegle-Neal Act includes a provision that allows individual states to “opt-out” of the law. States taking 1

advantage of this option include Texas, whose legislature voted to opt-out until 1999. The Montana legislature is

likely to opt-out until 2001, and the Colorado legislature passed an opt-out bill that was vetoed by the governor. 

As of May 1996, 24 states had decided to implement the Riegle-Neal provisions early, while 14 states had not yet

made an official commitment. See “Opt In? Opt Out? It Probably Doesn't Matter,” American Banker, 5-14-96,

and “Montana Groups: Branch Statewide, Hold Off Opting In Until 2001,” American Banker, 12-20-96.

1

Introduction

Financial services firms in the U.S. have faced dramatic increases in competitive

rivalry over the past decade. The erosion of laws limiting the geographic scope of

commercial banking organizations has profoundly changed the nature of this competition. 

Intrastate branching and interstate banking restrictions have been eliminated or relaxed in

most states, enabling large or growing commercial banks to enter an increasing number of

geographic markets. The most aggressive among these organizations have developed nearly

nationwide retail banking profiles. 

Aided by federal legislation, this geographic expansion is likely to continue, and

perhaps accelerate, in the near future. The Riegle-Neal Interstate Banking and Branching

Efficiency Act of 1994 removed federal restrictions on interstate banking as of September 29,

1995, and will remove federal restrictions on interstate branching on June 1, 1997. As these 1

provisions become fully effective, state legislatures, banking interests, policy makers, and

economists continue to debate the competitive consequences of geographic deregulation. 

The debate over the impact of Riegle-Neal is particularly germane for metropolitan

areas where clusters of small banks face potential entry by large, out-of-state institutions. 

Opponents of interstate banking argue that small local banks will not be able to compete with

large out-of-state banks. They contend that local markets will grow more concentrated, and

banks with large market shares will be able to increase fees on services, increase rates on

loans, and decrease rates on deposits. Opponents also argue that reductions in competitive

rivalry will reduce banks’ incentives to operate efficiently. In addition, opponents claim that
 Laws vary across states. Some states only allow entry by holding companies from bordering states, some 2

prohibit out-of-state banks from establishing or purchasing de novo subsidiaries, and some make special

exceptions for out-of-state acquisitions of failing banks. Typically, state laws at first permitted limited

opportunities for entry, but relaxed these restrictions over time. For more details, see Amel (1993) and Calem

(1993).

2

the loss of local control will allow savings to be siphoned from small markets with less

lucrative investment opportunities to large metropolitan centers with more vital economic

climates. Reduced access to financial services in these areas may hit small businesses

particularly hard, because these firms have few alternative sources of credit.

Supporters of interstate banking envision a much different scenario. They believe that

interstate banking and branching will lead to more competitive banking markets in which

depository institutions will have to operate efficiently or exit the market. Market

concentration will be less of a problem because, with greater geographic mobility, the

potential for entry will be a stronger deterrent. In general, supporters of the Riegle-Neal Act

believe that increased competitive rivalry will generally improve the quality and availability

of all types of financial services. 

Although the Riegle-Neal Act is the most far-reaching legislation allowing banking

companies to operate across state lines, it was not the first law to authorize interstate banking

or branching. Laws passed earlier by state legislatures allow out-of-state bank holding

companies to gain entry into most states simply by acquiring an existing bank, usually with

the stipulation that the holding company’s home state afforded reciprocal privileges. As the

number of states authorizing reciprocal compacts expanded in the 1980s and 1990s, more and

more banking companies gained access to markets in other states. 

2

To test the validity of arguments for and against interstate banking and branching, we

examine the performance of small, local banks operating in metropolitan areas into which outof-state entry was permitted prior to the enactment of the Riegle-Neal Act. In particular, we
3

test whether these banks became more cost efficient in response to entry by out-of-state

institutions allowed by state legislation. As long as market conditions are reasonably

competitive, improved cost efficiency should be associated with greater quantities of financial

services, higher quality financial services, lower prices for financial services, or all three. By

investigating these data, we are able to make some inferences about the likely impact of the

Riegle-Neal Act on local banking markets.

In Section 1 we discuss some of the previous research examining the impact of out-ofstate entry on local banking markets. In Section 2 we estimate an efficient cost frontier for a

cross section of U.S. commercial banks in 1992, and use the estimated frontier to generate a

measure of cost inefficiency for banks that operate primarily in local banking markets. In

Section 3 we test whether the cost efficiency of these local banks is related to the amount of

competition they face, or could potentially face, from out-of-state banking companies. In

Section 4 we present the results of these tests. In the years immediately following the

removal of barriers to out-of-state banks, we find that increased entry is associated with

increased inefficiency for local banks. However, this appears to be a short-run phenomenon

only -- in markets that have allowed out-of-state entry for at least six years, we find that

inefficiency declines in response to increased entry. On average, cost inefficiency at local

banks declines by about 3 percent for each additional year that banks face interstate

competition. In Section 5 we draw our main conclusions: (a) in markets for which RiegleNeal marks the introduction of interstate competition, local banks are likely to experience

gradual but substantial gains in cost efficiency, and (b) in markets where interstate

competition has already begun, Riegle-Neal will likely enhance competition by expanding the

number of potential entrants.
 For information on small bank lending to small businesses, see Bauer and Cromwell (1989), U.S. General 3

Accounting Office, Interstate Banking: Benefits and Risks of Removing Regulatory Restrictions (1993), and U.S.

Congress, "Impact of Bank Reform Proposals on Consumers," Hearing before the Subcommittee on Consumer

Affairs and Coinage, Committee on Banking, Finance, and Urban Affairs, House of Representatives, April 10,

1991. 

4

1. Related Research

There is little evidence that interstate banking and branching has reduced competition

in banking markets. Savage (1993) found no significant increase in the concentration of

banking markets over the past decade due to the elimination of branching restrictions. 

Thomas (1991) investigated the impact of interstate banking on competition in Florida

markets, and found that interstate branching increased the rate at which new banks were

chartered in local banking markets. Calem and Nakamura (1995) showed that branch banking

in densely populated urban markets tends to enhance competition in outlying geographic

areas without reducing it in urban centers.

Opponents of interstate banking argue that the number of small banks will fall, leading

to fewer loans, at higher prices, for small businesses. Unquestionably, small banks originate a

disproportionately large share of small business loans. Nevertheless, several studies have 3

concluded that entry by out-of-state institutions has not seriously affected small business

lending. For example, Rose (1993) found that, even though interstate banking resulted in

fewer banking organizations, and increased aggregate bank concentration, no significant

decrease in credit extended to small manufacturing firms occurred. Whalen (1995) found

similar levels of small business lending among in-state banks and out-of-state entrants in

Illinois, Kentucky, and Montana. Moreover, he found that out-of-state entrants charged lower

rates to small businesses than did in-state lenders, despite that fact that the out-of-state banks

incurred relatively higher marginal costs. Strahan and Weston (1996) examined how bank

mergers altered the pattern of small business lending between 1993 and 1995, and concluded
5

that future consolidation will not adversely affect credit availability to small businesses.

Proponents of interstate banking often argue that geographic expansion will allow

banks to diversify their deposit and lending bases, thereby allowing banking companies to

reduce risk, increase returns, or both. Existing studies have found no evidence to support this

contention. Chong (1991) and Hughes, Lang, Mester and Moon (1996) found that geographic

diversification can make a bank more risky in addition to increasing its profitability. Rose

and Wolken (1990) measured the cumulative change in local market share over time for both

independent banks and subsidiaries of geographically diversified banking companies. They

concluded that affiliation with a diversified parent generally provided no significant long-term

competitive advantage. Goldberg and Hanweck (1988) compared institutions that were

operating across state lines (grandfathered by the Bank Holding Company Act of 1956) with

other local institutions of similar size, and found no significant differences in performance,

market share, or efficiency between the two groups of banks.

Another set of studies suggests that the presence of out-of-state banks in local markets

will enhance market efficiency. Adkisson and Fraser (1990) found higher acquisition

premiums for institutions in states that permitted geographic expansions, and also concluded

that markets to which out-of-state depository institutions had easy access were more

competitive. Rhoades and Rutz (1982) found that the presence of a multi-bank holding

company (MBHC) in a local market had a positive effect on inter-firm rivalry, particularly on

non-price competition. Marlow (1982) observed lower mortgage interest rates in local

markets into which branch banking institutions had expanded. Laderman and Pozdena (1991)

concluded that actual and potential competition were greater in states that allowed interstate

banking. 

Whatever the competitive impact of nationwide banking and branching, however, it is
 See "Branching: A Trickle Instead of a Flood," American Banker, 7-18-96. 4

 By 1992, some form of out-of-state entry had been permitted for at least eight years in 11 states; for between six 5

and seven years in 20 states; and for less than six years in 17 states. See Amel (1995) for further details.

6

likely to occur slowly. Recent experience in states that have already opted-in to the RiegleNeal Act suggests a slow structural adjustment to nationwide branching. McLaughlin (1995) 4

studied the responses of bank holding companies between 1988 and 1993 to changes in state

laws concerning geographic expansion. She found that banking companies quickly

consolidated their existing bank affiliates within states, but expanded across state boundaries

more slowly. Calem (1993) investigated the decline in small banks over roughly the same

time period, and concluded that the relaxation of restrictions on intrastate branching had more

to do with this trend than did the more recent relaxation of interstate banking regulations. 

2. Estimating Cost Inefficiency

We begin our empirical investigation by estimating an efficient cost frontier for 3,997

U.S. commercial banks that were headquartered in metropolitan statistical areas (MSAs) in

1992. The cost frontier embodies 'best-practices' banking techniques, i.e., the lowest possible

level of expenses at which a bank can still produce its chosen output levels, holding the prices

of its inputs constant. Once we have estimated the efficient frontier, we generate estimates of

cost inefficiency for a subset of ‘local’ banks, i.e., banks that operate most or all of their

branches within a single MSA. Finally, we run regressions to test whether cost inefficiency is

related to the length of time that local banks have faced competition from out-of-state banks,

or with the share of the local market captured by out-of-state banks. 

We use 1992 data because, although most of the states had by that time passed laws

permitting some form of out-of-state entry, these laws were still relatively new in a number of

states. Consequently, 1992 data allows us to observe local banks that have been competing 5
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against out-of-state institutions for over a decade, as well as other local banks that have not

yet fully adjusted to the new competitive environment. We limit our data to urban banks for a

number of reasons: out-of-state banks typically enter urban markets; agricultural lending is an

important product for rural banks but not for urban banks; and rural banks use different

distribution channels (e.g., fewer branch locations) than do urban banks. 

We use a Fourier-flexible functional form, which combines a standard translog

functional form with a non-parametric Fourier functional form, to specify the cost function. 

McAllister and McManus (1993), Berger, Leusner, and Mingo (1994), Berger and DeYoung

(1995), and Mitchell and Onvural (1996) all have found that the Fourier-flexible form

dominates the translog for banking cost data. We estimate the following cost function:

where C is total (interest plus noninterest) expense; Y is a vector of outputs including

commercial loans, consumer loans, real estate loans, transactions deposits, and fee-based

income; and W is a vector of input prices including the prices of labor, physical capital, and
 Transactions deposits include demand deposits, NOW accounts, automatic transfer service accounts, and 6

telephone and pre-authorized transfer accounts. Fee-based income equals gross noninterest income less both

service charges on deposit accounts and gains (losses) from securities and foreign exchange trading. Fee-based

income is included to control for activities other than deposits and loans, such as off-balance sheet activities and

trust services. The price of labor equals salaries and benefits divided by the number of full-time equivalent

workers. The price of physical capital equals expenditures on equipment and premises divided by the book value

of physical assets. The price of borrowed funds equals total interest expense divided by total borrowed funds

less demand deposits.

 Stevenson (1980) has shown that the assumption of a truncated normal inefficiency distribution is more general 7

and more flexible than the assumption of a half normal distribution. Berger and DeYoung (1995) show that the

truncated normal distribution results in lower estimates of average inefficiency for banks than does the half

normal, but that the rank efficiency order of banks remains virtually identical across distributions.

 Factor share equations were omitted because application of the usual cross-equation restrictions imposes the 8

assumption that the given input proportions were the allocatively efficient ones (see Berger 1993, p. 266).

 Subtracting 1 from the anti-log of lnU yields this result: exp(.3144) - 1 = .3694. This transformation undoes the 9

double log form imposed on the data in the translog portion of the cost function.

8

borrowed funds. Following Berger, Leusner, and Mingo (1994), the Z terms are functions 6

that re-scale the lnY and the lnW terms so that they fall on the interval [.1*2B , .9*2B]. j m

Descriptive statistics for the cost function variables are displayed in Table 1. All data come

from the 1992 Reports of Condition and Income (call reports).

We estimate this cost frontier using the econometric frontier approach (EFA)

introduced by Aigner, Lovell, and Schmidt (1977) and Jondrow, Lovell, Materov, and

Schmidt (1982). In the EFA approach, the error term 0 in the cost function is a composite

expression, 0 = lnU + lnV, where lnU captures cost inefficiency and is distributed as a

truncated normal variable, and lnV captures random error and is distributed as a normal

variable. We use maximum likelihood estimation techniques, and impose the standard 7

symmetry and homogeneity restrictions on the translog portion of the model. For the average 8

bank in our overall sample of 3,997 banks, the estimated cost inefficiency term lnU equals

.3144. Transforming this result into percentage terms, the average urban bank in 1992

incurred expenses that were about 37 percent higher than those of an otherwise similar bank

that operated on the efficient cost frontier.9
 Tobit estimation techniques yield nearly identical regression results (not shown). 10

9

3. The Relationship between Cost Inefficiency and Out-of-State Entry 

Although we begin by estimating cost inefficiency for all urban banks in 1992, we are

most interested in the performance of urban banks located in states that allowed out-of-state

entry prior to 1992. Accordingly, we limit the remainder of our analysis to two subsamples of

banks in 1992: (a) the 1,864 banks with 100 percent of their branch offices in a single MSA

and (b) the 2,090 banks that drew at least 80 percent of their deposits from branch offices in a

single MSA, but also operated a small percentage of their branches in other MSAs or

counties. These subsamples contain only local banks, i.e., those banks that opponents of

interstate banking believe to be most vulnerable to competition from out-of-state entrants. 

Descriptive statistics for the banks in subsample (a) are displayed in Table 2. Note

that lnU ranges widely between .0282 and .9527, with a mean of .3380 and a standard

deviation of .1377. Our objective is to determine whether, and to what degree, this variation

in cost inefficiency is associated with differences in competition from out-of-state entrants. 

To make this determination, we estimate the following equation for both subsamples (a) and

(b) using OLS techniques:10

lnUi = 

 "0

 + $1*lnAGEi + 

 $2*OUTSHAREi

 + $3*lnAGEi*OUTSHAREi

+ $4*lnASSETSi + $5*ASSETGRi + $6*FAILASSTi + $7*CR3i

+ $8*NATIONALi + $9*BHCi + $10*UNRATEi + ,i

AGE is the number of years that have passed since bank I’s home state permitted some

form of out-of-state entry. We use the natural log of AGE in the regressions because any

changes in market performance are most likely to occur in the years immediately after barriers

to interstate entry are lifted, with diminishing effects in later years. lnAGE enters the
10

regression by itself and also interactively with OUTSHARE, the share of local market deposits

held by out-of-state banking institutions in 1992. The (double-log) partial derivative

MlnU/MlnAGE = $ + $ *OUTSHARE is the elasticity of cost inefficiency with respect to AGE. 1 3

A negative sign on this derivative indicates that the average local bank becomes more cost

efficient the longer it has been exposed to the potential for out-of-state entry, holding

OUTSHARE constant. The (semi-log) partial derivative MlnU/MOUTSHARE = $2 + $3*lnAGE

is the proportional change in cost inefficiency for a unit change in market share. A negative

sign on this derivative indicates that the average local bank becomes more efficient as out-ofstate market share increases, holding AGE constant.

We include a number of variables to control for economic and regulatory conditions. 

FAILASST is the annual average of failed bank assets to total banking assets in each MSA,

measured over the period of time that out-of-state entry was permitted. Since inefficient

banks are more likely than efficient banks to fail in the face of out-of-state competition,

interbank average cost inefficiency may be lower in MSAs that have experienced substantial

out-of-state entry. We include FAILASST to control for this phenomenon. CR3 is the 3-firm

concentration ratio, a proxy for the degree of competition in each MSA. We include CR3 to

control for the possibility that, as described by Leibenstein 1966, firms with market power

will exhibit high amounts of cost inefficiency because they face little competitive pressure to

control expenses. NATIONAL is a dummy variable equal to one in states that initially allowed

entry from banks in any state, and equal to zero if entry was initially limited to banks from

states in a single region. UNRATE is the rate of unemployment in bank i’s MSA.

We also include several bank-specific control variables in the regressions. lnASSETS

is the natural log of total assets held by bank i, and controls for relationships between bank

size and bank performance that were incompletely specified in the cost function. ASSETGR is
 At the means of the data, a one year increase in AGE from 6.17 to 7.17 years is a 16 percent increase. 11

Multiplying this increase by the elasticity -.1924 yields the result. Results were similar for regression [2].

 A three year increase in AGE from 5.17 to 8.17 years is a 58 percent increase. Multiplying this increase by the 12

elasticity -.1924 yields the result. 

11

the percentage increase in bank i's assets between 1989 and 1992, and controls for disruptions

in efficiency caused by above average growth, e.g., the acquisition of other banks. BHC is a

dummy variable equal to 1 if bank i is an affiliate of a bank holding company, and is included

to test whether members of bank holding companies are more successful than independent

banks in the post-interstate banking environment. 

4. Results

The results of the OLS regressions are displayed in Table 3. The coefficients on

lnAGE and lnAGE*OUTSHARE are both negative and statistically significant, suggesting not

only that local banks exposed to the threat of out-of-state entry become more cost efficient

over time (i.e., with increases in AGE), but also that these improvements occur more rapidly

as actual entry becomes more intense (i.e., with increases in OUTSHARE). Evaluating

MlnU/MlnAGE at the means of the data yields the elasticity of local bank efficiency with

respect to time, which equals -.1924 for regression [1]. Transforming this result into

percentage terms, an additional year of exposure to out-of-state competition is associated with

about a 3 percent reduction in cost inefficiency for the average local bank, holding out-ofstate market share constant. Although this annual reduction in cost inefficiency is small, the 11

cumulative effect over time can be substantial. For example, an additional three years of

exposure to out-of-state competition is associated with an 11 percent reduction in cost

inefficiency for the average local bank, again holding out-of-state market share constant. 

12

Opponents of interstate banking argue that concentrations of out-of-state banks will
 Amel (1993) documents these state-level market share ceilings. 13

 This result is obtained by multiplying .0040 by 2.5, the increase in OUTSHARE. Equation [2] yielded similar 14

results. 

 We also estimated an alternative version of equation [1] that used a linear AGE variable in place of lnAGE (not 15

shown). The linear results are comparable to the natural log results. In particular, MlnU/MOUTSHARE was

positive for small values of AGE, negative for large values of AGE, and zero at approximately AGE=7.

12

have deleterious effects on local banking markets, and a number of states limit the share of

statewide deposits that can be held by out-of-state banks. Consistent with these concerns, 13

the coefficient on OUTSHARE is positive and significant, suggesting that an increase in outof-state market share depresses local bank efficiency. This coefficient, however, only

captures the average relationship between OUTSHARE and lnU across MSAs that, in 1992,

had been exposed to interstate banking for varying amounts of time. Table 4 shows that the

impact of out-of-state market share on local bank efficiency depends on how much time local

banks have had to adjust to out-of-state entry. 

For banks in local markets just beginning to experience out-of-state competition,

marginal increases in out-of-state market share are associated with increases in cost

inefficiency. Evaluated for AGE=3.21 (two standard deviations below the sample mean), the

partial derivative MlnU/MOUTSHARE=.0040. Thus, an additional two and one-half market

share points held by out-of-state banks (an approximate 10 percent increase from the sample

mean) is associated with about a one percent increase in cost inefficiency at the average local

bank. In contrast, the regression yields qualitatively different results for local markets in 14

which out-of-state entry had been permitted for a longer period of time. Evaluated for

AGE=9.13 (two standard deviations above the sample mean), MlnU/MOUTSHARE=-.0025. 

For these markets, an additional two and one-half market share points held by out-of-state

banks is associated with about a six-tenths of one percent decrease in cost inefficiency for the

average bank. 

15
13

There are a number of reasons that entry by out-of-state banks could initially impose

costs on local institutions. Out-of-state holding companies typically enter the local market by

purchasing an existing local bank. Buying out existing managers, merging back office

systems, and undertaking the marketing efforts necessary to establish name recognition and

retain depositors can temporarily disrupt operations and raise costs at these banks. Moreover,

other local banks may increase their marketing expenditures in an attempt to steal customers

away from the entrants. For local banks that purchase branch locations sold by the new

entrant, converting these branches also requires additional expenditures. Our results suggest

that these disruptions fade away over time as local banks adjust to interstate competition and

as the cost-reducing effects of branch closings, lay-offs, and other cost-cutting efforts take

effect. 

A number of control variables have statistically significant coefficients. The

coefficient on lnASSETS is negative, an indication that cost inefficiency declines with bank

size. Although this is certainly a plausible relationship -- large banks should be better able

than small banks to attract and retain high quality managers -- there is no consensus on this

issue in the bank cost efficiency literature. Berger, Hunter, and Time (1993) review the

evidence on this issue. The coefficient on CR3 is positive, suggesting that banks in

concentrated markets do not fully exploit their market power. This result is consistent with

Leibenstein's (1966) original characterization of X-inefficiency as slack managerial

performance in the presence of market power. The coefficient on FAILASST is negative,

indicating that the banks that exited local markets after out-of-state entry began tended to be

relatively inefficient banks. Controlling for this result bolsters our main finding, i.e.,

competition from out-of-state institutions improves local market efficiency not only because it

causes poorly operated banks to fail (it does, and we control for it), but also because it forces
 Given the ad hoc nature of the regression model, we use two tests for significant specification bias. One of the 16

tests used is called RESET (regression specification errors test). In its simplest form, the procedure involves rerunning the regression with the square of the predicted value of the dependent variable added as a regressor. If

the coefficient on this added variable is not significantly different from zero, then the null hypothesis of nospecification-error cannot be rejected (Ramsey 1969, and Ramsey and Schmidt 1976). We conducted this test for

all of regressions in Tables 3 and 4, and could not reject the null hypothesis in any of the regressions at any

meaningful level of significance. We also used the White (1980) specification test. The t-statistics reported in

Tables 3 and 4 use White's heteroscedasticity corrected covariance matrix whenever the White test rejects the

specification at the 5 percent level. The White specification test could not reject the specification at 5 percent

level in any of the regressions. 

14

banks that remain in the market to become more cost efficient. The coefficient on BHC is

negative, which suggests that affiliates of bank holding companies have an efficiency

advantage over independent banks in local markets. The coefficients on ASSETGR, UNRATE,

and NATIONAL all are statistically nonsignificant. Both of the regressions have relatively low

goodness-of-fit, with adjusted R-squares of about 13 percent. Because the dependent 16

variable in these regressions is an estimated error term from another model, and is not an

observed random variable, providing a good statistical fit is difficult.

5. Conclusions

In June 1997, the Riegle-Neal Act will allow U.S. commercial banks to bank freely

and branch freely across state lines, ending over a half century of federal restrictions that

limited interstate competition among banks. Banking interests, policy makers, and financial

economists are anxious to observe the impact that unfettered geographic growth will have on

interbank rivalry and banking market efficiency. Opponents of interstate banking have

argued that small local banks may be at a competitive disadvantage against large out-of-state

institutions, resulting in increasingly concentrated local banking markets. If this occurs,

opponents argue, financial services will become less available and more expensive, especially

for small businesses and retail customers. They also claim that large out-of-state banks will

siphon financial capital away from local markets. In contrast, supporters of interstate banking
15

foresee increasingly more competitive banking markets in which inefficient depository

institutions that do not offer reasonably priced, high quality financial services risk acquisition

or failure. 

To test the validity of arguments for and against interstate banking and branching, we

examine data from states that passed interstate banking laws prior to the Riegle-Neal Act. 

Limiting our focus to local banks that operated branches primarily in single MSAs in 1992,

we generate estimates of frontier cost inefficiency for each bank and then regress these

estimates on a variety of other economic and financial variables. In the years immediately

following the removal of barriers to out-of-state banks, we find that increased entry is

associated with increased inefficiency for local banks. However, in markets that have allowed

out-of-state entry for at least six years, we find that inefficiency declines in response to

increased entry. On average, cost inefficiency at local banks declines by about 3 percent for

each additional year that banks face interstate competition.

What do our results portend for the performance of local banks under the Riegle-Neal

Act? Interstate competition is already well under way in many metropolitan markets because

of state-by-state reciprocal compacts. For local banks in these markets, the forces of

competition have already begun to identify and eliminate inefficiency, although Riegle-Neal

may enhance these trends by expanding the number of potential entrants. Our results are

most relevant for banks operating in markets for which Riegle-Neal marks the first

introduction of interstate competition. For local banks in these markets, our results suggest

that interstate competition will gradually deliver substantial gains in cost efficiency over the

course of the next decade. 
16
17

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20

Table 1 

Descriptive Statistics -- Cost Frontier Variables*

Percentage of Assets

Mean Deviatio Mean Deviation

Standard Standard

n

Price of Labor ($ thousands) 31.69 7.56 -- --

Price of Capital (%) 0.44 0.55 -- --

Price of Funds (%) 0.05 0.17 -- --

Commercial Loans ($ millions) 17.13 30.55 10.69 7.88

Consumer Loans ($ millions) 20.09 204.39 40.76 17.14

Real Estate Loans ($ millions) 47.49 69.38 31.50 13.80

Transactions Deposits ($ millions) 38.93 54.30 27.19 9.53

Fee-Based Income ($ millions) 1.06 3.07 0.63 2.11

Total Costs ($ millions) 10.22 13.56 7.18 2.01

* Data for 3,997 U.S. Commercial Banks in Metropolitan Statistical Areas in 1992.
21

Table 2 

Descriptive Statistics -- Ordinary Least Squares Regression Variables*

Mean Deviation Minimum Maximum

Standard

Cost Inefficiency (lnU) .3380 .1377 .0282 .9527

Age (years since law changed) 6.17 1.48 1 11

lnAGE 1.78 0.31 0 2.39

Assets ($ thousands) 147.44 198.55 2,920 2,009,390

lnASSETS 11.31 1.05 7.98 14.51

ASSETGR (%) 21.62 8.11 -2.73 28.65

OUTSHARE (%) 24.74 22.30 0 96.64

CR3 .5690 .1392 .3256 .9950

FAILASST (%) 2.86 5.82 0 47.58

BHC (dummy) 0.71 0.45 0 1

NATIONAL (dummy) 0.07 0.25 0 1

UNRATE (%) 6.93 1.40 2.90 11.40

 

* Data for 1,864 U.S. Commercial Banks with 100% of their deposits in a single Metropolitan

Statistical Area in 1992.
22

Table 3

OLS Regressions Results*

Independent

Variables

Dependent Variable: Cost Inefficiency (lnU)

[1] [2]

Banks with 100 percent of Banks with 80 percent of 

deposits in the same MSA deposits in the same MSA

Coefficient Coefficient

estimate t-statistic estimate t-statistic

Intercept .1145 11.30 .1230 16.70 *** ***

lnAGE -.0394 2.23 -.0352 2.82 ** ***

OUTSHARE .0112 3.01 .0088 4.67 *** ***

lnAGE*OUTSHAR -.0062 2.45 -.0053 3.68

E

** ***

lnASSETS -.0026 4.64 -.0038 5.02 *** ***

ASSETGR .3158 0.92 .3062 1.26

CR3 .0124 1.90 .0136 3.83 * ***

FAILASST -.0134 1.87 -.0324 2.03 * **

BHC -.0042 3.34 -.0057 1.83 *** *

NATIONAL -.0213 1.06 -.0363 1.04

UNRATE -.0090 1.39 -.0158 1.06

adjusted R .1258 .1377 2

N 1,864 2,090

*Data includes only U.S. commercial banks in Metropolitan Statistical Areas (MSAs) located in

States that allowed out-of-state entry in 1992. , , and indicate different from zero at the 1, *** ** *

5, and 10 percent levels of significance, respectively.
23

Table 4 

The Impact of a 21⁄2 Point Increase in Out-of-State Market Share on Cost Inefficiency*

AGE AGE lnAGE MlnU/MOUTSHAR % Change in lnU

mean - 2 std. dev. 3.21 1.17 0.0040 1.00%

mean - 1 std. dev. 4.69 1.55 0.0016 0.40%

mean 6.17 1.82 -0.0001 -0.03%

mean + 1 std. dev. 7.65 2.03 -0.0014 -0.35%

mean + 2 std. dev. 9.13 2.21 -0.0025 -0.63%

*Results are evaluated at the means of the data for banks with 100 percent of their deposits in

a single Metropolitan Statistical Area.