Does Regional Economic Performance Affect Bank …

1 does Regional Economic PerformanceAffect bank Conditions?New Analysis of an Old Question Mary Daly, John Krainer, and Jose A. LopezFederal Reserve bank of San FranciscoEconomic Research Department101 Market StreetSan Francisco, CA 94105 Draft date: November 28, 2003 Abstract: The idea that Regional Economic Performance affects bank health is intuitive andbroadly consistent with the aggregate banking data. That said, micro-level research on thisrelationship provides a mixed picture of the importance, size, and timing of Regional variablesfor bank Performance .

2 This paper helps reconcile the heterogeneous findings of previousresearch by: (1) employing a unique composite measure of Regional Economic performancethat combines several Regional indicators into a single index; (2) constructing bank -specificmeasures of Regional Economic conditions, based on bank deposit shares, that account forbanks presence in several states; and (3) estimating models for all banks and intra- and inter-state banks separately. Empirical results based on this bank -specific composite regionalmeasure point to a tractable link between Regional Economic Performance and bank health.

3 The importance of Regional variables holds for both intra- and inter-state banks. Out-of-sample forecasts indicate that the composite index also helps tie down the relative riskiness ofbank portfolios across states. Finally, although interstate banks do seem to diversify awaysome of their portfolio risk, our analysis suggests it is too soon to conclude that interstatebanks are immune from Regional influences. Acknowledgments: The views expressed in this paper are those of the authors and not necessarily those of theFederal Reserve bank of San Francisco or the Federal Reserve System.

4 We thank seminar participants at theConference on the Use of Composite Indices in Regional Economic Analysis, the Federal Reserve SystemConferences on banking studies and Regional studies, and Fred Furlong, Andy Haughwout, Leonard Nakamura,Marc Saidenberg, James Stock, and Rob Valletta for helpful comments. We thank Liz Laderman for sharing thesummary of deposits data with us, Anita Todd for editorial assistance, and Jackie Yuen and Ashley Maurier forexcellent research Regional Economic PerformanceAffect bank Conditions?

5 New Analysis of an Old Question Draft date: November 28, 2003 Abstract: The idea that Regional Economic Performance affects bank health is intuitive andbroadly consistent with the aggregate banking data. That said, micro-level research on thisrelationship provides a mixed picture of the importance, size, and timing of Regional variablesfor bank Performance . This paper helps reconcile the heterogeneous findings of previousresearch by: (1) employing a unique composite measure of Regional Economic performancethat combines several Regional indicators into a single index; (2) constructing bank -specificmeasures of Regional Economic conditions, based on bank deposit shares, that account forbanks presence in several states; and (3) estimating models for all banks and intra- and inter-state banks separately.

6 Empirical results based on this bank -specific composite regionalmeasure point to a tractable link between Regional Economic Performance and bank health. The importance of Regional variables holds for both intra- and inter-state banks. Out-of-sample forecasts indicate that the composite index also helps tie down the relative riskiness ofbank portfolios across states. Finally, although interstate banks do seem to diversify awaysome of their portfolio risk, our analysis suggests it is too soon to conclude that interstatebanks are immune from Regional Regional Economic Performance Affect bank Conditions?

7 New Analysis of an Old Question I. IntroductionThe idea that Regional Economic Performance affects bank condition is intuitive andeasy to see in the banking data. As Figures 1 and 2 suggest, even regions in close proximity toone another display quite different time-series behavior in standard measures of both bankasset quality and bank Performance . Moreover, comparisons of state output growth andmovements in non-performing loans suggest a relationship between bank health and regionaleconomic conditions (Figure 3).

8 Despite these patterns in the data, establishing the precisenature of the relationship between bank health and Regional Economic conditions has provendifficult. Overall, the literature on this issue provides a mixed picture of the importance, size,and timing of Regional indicators in models of bank conditions. The heterogeneity of the empirical results reflects, in part, variation in measures ofregional Economic Performance , differences in model specification, and dissimilarities in thetime-periods of study.

9 In terms of variable selection, researchers examining the relationshipbetween Regional variables and bank condition have looked for Regional measures with thesame frequency as the banking data meaning monthly or quarterly Regional indicators. Thishas limited the set of potential Regional indicators to components of gross state product (GSP),the Gross Domestic Product (GDP) analog for states. For instance, researchers have used oneor more variables such as employment growth, personal income growth, and commercial andresidential real estate values, entering these variables contemporaneously, as lagged values,and as forecasts.

10 Model specifications also vary in whether variables are entered as levels,1 Later in the paper we show that the decreased correlation between state output growth and statenon-performing loan ratios owes to convergence across states in both variables. 2changes, or deviations of both of these from a national mean. By and large, each of thesespecifications yields different results, especially in terms of the Economic importance ofregional indicators in models of bank health. Along with differences in variable selection and model specification, heterogenousresults have come from differences in the time periods under study.