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Byline: Scott Hein The U.S. economy is changing, forcing banks to examine how they operate. With strengthening GDP growth, falling unemployment and recent increases in the Federal Reserve's target range [...]

To the public, all banks seem alike. But banking insiders make important distinctions between community banks and all other banks. Policymakers worry that community banks' unique characteristics threaten their survival in the lace of industry consolidation. However, despite dramatic regulatory and technological changes in the industry in the past two decades, community banks have not only survived but often prospered. This article explores the differences between community banks and larger banks to discover what makes community banks unique. Large banks engage primarily in transactional banking--the provision of highly standardized intermediation services, such as gathering deposits and extending loans, that require little human input to manage. Community banks, in contrast, typically focus on relationship banking, which requires more human input, more detailed credit evaluation, and localized decision making. Examining profit and risk measures for the 1998--2002 period for both community banks and large banking organizations, the authors find evidence that small banks were generally profitable. In all but the smallest size category, community banks have performed as well as, and often better than, large banks in managing net interest margins, aggregate profits, and credit risk. Also, community banks are more likely to adopt Subchapter S tax status, which allows them to avoid direct federal income taxation and pass tax benefits on to shareholders. These institutions typically have relatively higher returns on both equity and assets than larger banks do. Whether community banks will be able to sustain this good performance will depend, the authors conclude, on how well managers find valuable relationship lending niches, invest bank capital, and balance asset quality with growth., A number of years ago in Lubbock, Texas, where the three authors once lived, the market was served solely by community banks, each with a different strategic focus and emphasis. [...]

The discussion in many money and banking textbooks would suggest that the Federal Reserve requires depository institutions to hold a minimum level of non-interest-earning reserves because (1) reserve requirements are a monetary policy tool that allows the Fed to expand the money supply and lower interest rates, and (2) reserve requirements improve the safety and soundness of depository institutions. This article argues that this 'conventional wisdom' view is too narrow. The Fed often uses reserve requirement changes, the authors contend, to achieve non-monetary-policy objectives, as it did in 1992 to improve the profitability of depository institutions and ease the credit crunch of that time. The authors also challenge the notion that higher reserve requirements necessarily lead to greater safety and lower default risk for depository institutions. The article examines the relationship between reserve requirement changes and monetary policy, with the aim of demonstrating the recent, limited usefulness of reserve requirements as a monetary policy tool. The authors propose a more modern view of reserve requirements as a tax on depository institutions, ponder who really bears this tax, and summarize a large and growing literature suggesting that perceived bank profitability is inversely affected by announced changes in reserve requirement ratios. The article also provides new evidence that the 1992 reserve requirement reductions were not associated with an increase in default risk for financial institutions that issue reservable instruments, as the conventional view would suggest., The Federal Reserve requires depository institutions to hold a minimum level of non-interest-earning reserves (vault cash or deposits at the Fed) in proportion to their depository liabilities. A cursory reading [...]

The monetary base is the sum of high-powered money and an adjustment factor that measures changes in reserve requirement ratios. This adjustment factor is calculated so that it responds to changes in deposit levels in addition to changes in reserve requirements. Consequently, researchers and policymakers using the monetary base are seeing a mixture of changes implemented through open market operations, discount window borrowings, and reserve requirements, together with nonpolicy actions acting on deposit flows. Joseph Haslag and Scott Hein calculate the reserve step index (RSI) to separate changes in one of the available adjustment factors - the St. Louis Federal Reserve Bank's Reserve Adjustment Measure (RAM) - into pure reserve-requirement effects and deposit-flow effects. RSI would give analysts a measure that responds only to changes in reserve requirement ratios. Haslag and Hein also provide statistical evidence suggesting that combining RSI and the deposit-flow effect, as RAM does, is not justifiable in simple reduced-form models of nominal GNP growth, output growth, or inflation.

A pricing model for Municipal Bond Index futures (MBI) was developed which incorporates a cash-and-carry framework. The model was validated using actual data from MBI municipal bond prices from 1985 to 1990. Results indicate a strong correlation between closing price declines and major revisions in MBI values. In addition, the frequency of upper and lower boundary violations were strongest during the initiation of MBI futures contracts.

Some critics of recent monetary policy have focused on slow M2 growth, claiming that the Federal Reserve is too interested in price stability and is forsaking its growth mandate. Others criticize the Fed for achieving price stability too cautiously and urge the adoption of a rule that seeks to eliminate inflation more quickly. R.W. Hafer, Joseph Haslag, and Scott Hein examine two alternative monetary policies and gauge their expected impacts on economic activity. Both policies are simulated over the period 1987-92. One policy, a GNP-targeting rule similar to one proposed by Bennett McCallum, slows nominal GNP growth substantially. Simulated nominal GNP, however, is quite volatile under the GNP-targeting rule. The other policy, referred to in the article as the M2-targeting approach, seeks to hit the midpoint of the M2 target cones. The authors find that although adopting the M2-targeting approach would have resulted in somewhat faster average nominal GNP growth compared with what actually occurred, the start-and-stop pattern exhibited during the recent U.S. recovery would still be present. Thus, the evidence indirectly supports the notion that real shocks were the driving force behind recent weakness in economic activity.

A study was conducted to evaluate market efficiency based on alternative tests of weak-form futures market efficiency. The study extends earlier research studies and considers methods rooted on forecast efficiency and rational expectations. The study applies Treasury-bill futures markets as asample. Results show that Treasury-bill futures markets are not as inefficient as previous research has shown.

Byline: Scott E. Hein It's a well-known fact that the Federal Reserve aims for an inflation rate of 2%. What's less clear is whether the logic behind this goal holds [...]

The traditional monetarist view is upheld over the credit view as shown by the non-effects of business loan announcements of commercial banks on market interest rates. Credit view proponents have argued that aggregate commercial bank lending decisions have strong macroeconomic effects while the monetarist view holds that it is sufficient to consider the liability side of the banking sectors's balance sheet in analyzing economic outlook. Unexpected money supply developments, however, are found to cause interest rate adjustments. Several limitations of this study are spelled out, though.

Analysts' forecasts of long-term earnings growth for electric utilities are usually more precise than forecasts derived from the projections of models. However, combined forecasts applied to out-of-sample data are not more accurate. The valuation tests of alternative forecasting techniques provides substantial evidence that investors place great confidence in earnings forecasts from Value Line Inc.

Byline: Scott E. Hein Last month, Fed Reserve Chairman Ben Bernanke addressed the House Financial Services Committee. Here is what I wish he had said: The Federal Reserve has been [...]

On Sept. 29 the Federal Deposit Insurance Corp. proposed that banks prepay their deposit insurance assessments for the fourth quarter of 2009 and all of 2010-2012. If approved, the plan [...]

It was good to hear Treasury Secretary Timothy Geithner state that 'community banks play a vital role in our financial system and a central role in our economy.' Of course, [...]