COMMERCIAL BANK PORTFOLIO BEHAVIOR AND THE COMMERCIAL LOAN MARKET

THIS STUDY constructs a commercial bank portfolio model based on expected profits maximization where there is uncertainty regarding future levels of deposits and other liabilities. Aggregate Federal Reserve data is used in the empirical sections. The model is presented in a dichotomized form: first, the trade-off between cash assets and earning assets is analyzed under the assumption that the earning assets are perfect substitutes; later, the model is expanded to include a wider breakdown of assets. Aside from expositional convenience, this approach enables the author in the earlier sections of the study to investigate a variety of issues commonly encountered in conventional money supply-money demand analysis. Among these are: (a) The question whether aggregate free reserves or its components, excess reserves and borrowed reserves, is the more appropriate behavioral variable both in theory and from the standpoint of convenience for empirical research. The study concludes in favor of free reserves, showing that if portfolio adjustments are rapid (and this is verified in a section of the study), borrowed reserves can be better predicted with an indirect method developed by the author which first uses a free reserve equation, then transforms predicted free reserves into predictions of borrowed reserves. (b) The functional form of the free reserve demand function. The functional form developed theoretically, and supported by a number of tests in this study, suggests that banks have tended to accelerate borrowing as the ratio of the Treasury bill rate to the discount rate approaches a value slightly greater than unity. This evidence is supplemented by tests of several implications of the theoretical demand curve, including the effects of the 1959-1960 change in Regulation D, and the significance of transaction costs (including a measure of the differences between country and city bank transaction costs). The author finds no evidence of "risk aversion"; rather it appears that banks, at least in the aggregate, managed their free reserves in such a way as to maximize the mathematical expectation of return. (c) The speed with which banks respond to unplanned flows of available funds and changes in interest rates. This study provides evidence that free reserves and other assets adjustments are far more rapid over periods as long as a quarter than has been concluded in much of the recent literature. A number of tests are also shown which belie the interpretation of free reserves as a cyclical buffer; the buffer function of free reserves appears to take place in a much shorter time interval. Expanding the assets categories, the author develops conditions under which expected profits maximization will lead to asset diversification. For the least "liquid" category considered, "nonprime" commercial loans, the model is useful for examination of the rationing hypothesis and the so-called "loan accommodation principle", under which banks are constrained by longer run profit considerations to grant loans upon demand to favored customers. The study offers tentative evidence that "nonprime" loans (nonprime commercial and other) are rationed by quantity rather than by other terms. On the other hand, loans to prime borrowers are shown to be financed by reductions in all other earning assets, most importantly nonprime commercial loans.