Analysis of the portfolio behavior of black-owned commercial banks.

ABSTRACT

Several studies have been done and conclusions drawn on the operating efficiency of black-owned banks. This study differs because it did not seek to compare the economic performance of black-owned banks to non-black-owned banks. Rather, the study attempts to explain their asset choice, determinants of bank loans, using the profit maximization versus the loan accommodation principles models. The result suggests that, the management of black-owned commercial banks is straddling between both approaches to asset choice.

1. INTRODUCTION

The economic history of African-Americans reveal that the first financial institution--the first black-owned bank in the United States--was the Capital Savings Bank established in Washington, D.C. October 1888 followed by the Savings Bank of the Grand Fountain, United Order, True Reformers which opened April 1889. Their primary functions were no different from the normal intermediation function of financial institutions, one of which is to help finance the purchase of homes and other related activities.

The inception and growth of black-owned financial institutions grew out of the need for blacks that were denied access to capital by the majority financial institutions to form their own financial institutions. In the particular case of Tide Water Savings and Loan of Virginia, "the freed blacks wanted homes for their families, but found it extremely difficult to get the necessary capital from white lending institutions" (Black Enterprise Magazine [BE], October 1972). The history in the case is not different from most. Even when black have achieved qualified economic status and have good credit rating, they were still denied access to capital. Being a veteran of both World War I & II did not make any difference. "Both servicemen and civilians found to their disappointment and horror that the (White) banks which held their savings did not consider them good credit for loans to purchase homes" (BE October 1972).

Some have argued that the behavior of black-owed banks cannot be completely divorced from its history. During 1888-1934, 134 black-owed banks were formed mostly in the Southern States. The depression of the 1930's led to the closure of most of these banks. By 1969, there were only 22 black-owned banks in the United State. That number grew to 50 banks in 1976 and fell to 29 in 1979. The 1980's were a very terrible decade for the banking industry as a whole. In 1986, 145 banks failed, that number was 203 in 1987 and 221 in 1988. For black-owned banks there were 47 banks in 1983, which declined to 35 banks in 1988. The number of black-owned banks gradually increased during the 90s, picked at 38 in 1991, and since then there has been a gradual decline to where the Black Enterprise Magazine only reports data on 25 banks (financial institutions).

While the number of black-owned banks continues to decline the amount of their total assets grew 13 fold from $324.6 million in 1970 to $4336.97 million in 2001. The growth in total loan was more remarkable; it went from $135.45 million in 1970 to $2562.043 million in 2001, an increase of 19 fold. The amount of total deposits in black-owned commercial grew from $267 million in 1970 to $3556.638 million in 2001. These banks have also been a source of employment. In 1970 there were roughly 834 people employed, that number grew to 1831 in 1979. The 1980s began with an early growth in employees, starting from 1987, that number has declined yearly even into the 90's. The growth in assets despite the decline in the number of banks is one of the motivations for this study.

2. PREVIOUS STUDY

The performance of black banks has been extensively studied. Some of the seminal works include those done by Andrew Brimmer (1971), Edward Irons (1972), Maurice Emeka (1973), William Bradford (1974), John Boorman (1974), Edward irons, Samuel Doctors, and Allan Drebin (1975), Tom Bates and William Bradford (1980), Robert T. Clair (1988), William Scott (1988), Mehdian and Elyasiani (1992), and recent study by Iftekhar and William Hunter (2000).

These studies can be loosely grouped into two types. One group of studies focused on the impact of these banks on the economic development in their service areas. Essentially, did these banks accomplish the twin objectives of black economic development and empowerment? The second group of studies compares the economic efficiency (operating efficiency) and long-term survival prospects of black-owed to non-black owned banks.

The studies by Brimmer (1971), Bates and Bradford (1980), Kwast and Black (1983) which compared the economic performance of black-owned to other nonminority owned banks, found that even when other factors are held constant, black-owned banks have lower returns on assets, higher loan losses, and are less profitable compared to non-minority banks. Some of the reasons offered for this poor performance lie in the nature of the market in which these banks operate. Brimmer (1971) wrote: "the inherent risk of doing business in the urban ghetto, the high unemployment rates, low family incomes, the high failure rates among small businesses (compounded by high crime rates) make the ghetto an extremely risky place for small banks to lend money". The very nature of the market makes it very difficult for black-owned banks to completely achieve the twin objective of economic growth and empowerment within the black community.

Bates and Bradford (1980) disagreed with Brimmer's conclusion that black banks did not have the potential and managerial skills to effectuate black urban economic development. They wrote; "Our conclusion is that Black and non-minority banks respond similarly to the relevant stock and flow variables that shape their environments, with observed differences in portfolio composition tracing to differences in their particular vectors of operative influences. Black banks should be viewed as institutions facing typical small bank problems. Thus, the analysis of Brimmer and others critiquing the liquidity of these banks' portfolio is deemed inappropriate."

The study by Clair (1988), on operating efficiency of black-owned banks concluded that, when black-owned banks are compared to non-minority owned banks in the same zip-code region, the differences in "loan losses or in labor or occupancy expenses" tend to disappear. However, even after adjusting for location differences, the return on assets is still lower in black-owned banks compared to non-black-owned banks. However, more recent studies conclude that "minority-owed banks had significantly improved their capital ratios and decrease their holdings of liquid assets, while expanding their use of purchased funds" Hasan and Hunter (2000). Using a production function efficiency model approach instead of a review of financial ratios, Hasan and Hunter arrived at similar conclusions as previous studies--"it appears that minority and women-owned banks were relatively inefficient institutions" (Hasan and Hunter, 2000).

3. THE THEORY AND MODEL

This study is different from other studies already mentioned. It does not seek to compare the economic performance of black-owned banks to non-black-owned banks, rather, it seeks to find out, on a macro sense, if black-owned bank asset choice is governed by profit maximization principles or are they just accommodating load demands? This knowledge is important because whatever approach defines not only their asset choices but also their reaction to Federal Reserve monetary policy and/or broad changes in economic activities. The study of bank portfolio behavior is an important explanatory factor for changes not only of the aggregate economic activities but also a key determinant of the cost and flow of credits to specific sectors of the economy. However, given the nature of the scarcity of data on black-owned banks, this study is restricted to looking at their loan portfolio. A more exhaustive model would consider bank behavior towards total deposits, excess reserve, investments, etc.

The study validation of any of the proposed theory has implication for the entrepreneurial stance or approach of the management of these banks. Black banks like private enterprises in a market economy have among other goals, the goal of maximizing the wealth of shareholders. Asset choice is one of the components in the myriad of decisions management has to make that eventually leads to the goal of maximizing the wealth of shareholders.

Simply put, the institutional or traditional approach to commercial bank portfolio behavior posits that, given the nature of the balance sheet items of commercial banks, banks make series of decisions concerning the composition of its assets. First, the bank meets its legal required reserve commitments. Second, it determines the size of its secondary reserve holdings, third, meets customer credit demands. Finally, given that it has satisfied the need for safety and met customers' demand for loans, the remaining fund is used for investment. This approach, while it provides us with some insight into bank behaviors, is devoid of any optimization or marginal analysis. However, if black-owned banks adhere to the accommodation principles, then studies designed to assess management reaction to market forces would be missing the points. As long as the economy is growing, banks will continue to find ways to accommodate loans.

The dynamic portfolio approach improves on the static equilibrium model. It introduces risk aversion. The problem of portfolio selection is reduced to the goal of maximizing expected utility subject to the trade-off between risk and rate of return available from the set of efficient portfolio.

The studies of dynamic approach to commercial bank portfolio behavior can be grouped into two strands--micro and macro models. The micro approach to bank portfolio behavior asserts that banks are assumed to minimize total adjustment costs for a given adjustment period to a net liquidity constraint. Recent micro approach feature the use of "stochastic cost frontier to calculate a measure of production efficiency (an inefficiency score) for each bank" Hasan & Hunter (2000).

A common thread that runs through the macro (aggregate) model is the stock adjustment thesis and the relationship between commercial bank portfolio behavior and money supply. This study investigates two alternative hypotheses about black-owned commercial portfolio behavior using aggregate data for all black-owned banks. These are the accommodation principle and the profit maximization principle.

The accommodation principle which is derived from the old "real bills doctrine" or "commercial loan theory" espouses the following--that bank earning assets should be limited to (a) short term loans and (b) to self liquidating loans related to the production and distribution of goods and services. Demand for such bank loans determines their portfolio behavior. This principle posits the following regression model:

(1) L = [A.sub.1] - [[beta].sub.1][i.sub.S] + [[beta].sub.2][i.sub.L] + [[beta].sub.3]GDP + [[mu].sub.t]

Where: L = supply of loans in dollars, [[beta].sub.1]'s = regression coefficients, [A.sub.1] = a constant is = short-term interest rate postulated to be negatively related to L, [i.sub.L] = long-term interest rate positively related to L, GDP = Gross Domestic Product positively related to L and [[mu].sub.T] is the error term.

According to the accommodation principles, reduction in the growth of overall liquidity in the economy would have little or no effect on the volume of bank loans if the demand for such loans at given interest rates was expanding rapidly. If bank asset choices are determined by the accommodation principle, lending behavior are closely related to changes in economic activity. Black-owned banks in this case will continue to make loans as long as there is economic growth. One rationale being that good economy begets greater employment and the increase probability of no default on loans.

The profit maximizing principle stipulate that commercial bank behavior are guarded by the motive of profit maximization within a given budget constraints. Commercial bank responses to market forces determine their portfolio behavior. This model posits the following regression model:

(2) L = [A.sub.1] + [[beta].sub.1][i.sub.S] - [[beta].sub.2][i.sub.L]

All variables remain as defined in equation (1). L = supply of loans are positively related to short-term interest rates and negatively related to long-term interest rate.

Under the profit maximizing principle, bank supply of loan would be positively related to short-term interest rates and negatively related to long-term interest rate. If black-owned banks were profit maximizing, their portfolio behavior will respond to changes in short-term and long-term interest rates and not to changes to GDP. When short-term rates rise banks will respond by increasing their ratio of loan to deposits, but, as long-term interest rate rises, investments become more attractive than loans. If Black banks ascribe to the profit principles, management decision is greatly influenced by the changes in the market price of assets. When returns are higher given the level of risk from other assets other than loans, the profit maximizing principle dictates a shift towards those assets.

Combining equation (1) and (2) result in estimating the following reduced equation:

(3) L/D = f([i.sub.S], [i.sub.L], GDP/D, [[L/D].sub.-1])

Equation (3) assumes that each function is homogenous with regards to deposits (D) hence each variable in dollars is divided by D. The variables are defined as follows: [i.sub.S] = short-term interest rate approximated by the 91-day Treasury bill rate, [i.sub.L] = long-term interest rate approximated by the corporate Aaa bond rate, [[L/D].sub.-1] enters the equation as a lag variable. It is assumed that banks have desired levels of loan and the stock of loan held changes at a certain rate to close the gap between the actual and desired level. We can assume that the desired stock may depend on such economic factors as the prevailing interest rate structure and the level of Gross Domestic Product. Part of the goal of management may involve the closing of the disequilibria between desired and actual. This relationship can be expressed in the following equation:

(4) [X.sub.t] - [X.sub.t-1] = [lambda]([X.sup.*.sub.t] - [X.sub.t-1]) [X.sub.t] = [lambda][X.sup.*.sub.t] + (1-[lambda])[X.sub.t-1]

Where: [X.sub.t] is the stock at time t, [X.sup.*.sub.t] is the desired stock, [X.sub.t-1] is the stock in the previous periods, and [lambda] is the speed of the adjustment coefficient. The next section presents and discusses the findings of this study.

4. STUDY RESULTS AND CONCLUSIONS

Before delving into any great detail about the empirical results, it is pertinent to mention the nature and source of the data used for this study. Data on interest rates and Gross Domestic Product were extracted from various issues of the President Economic Report. The data on loans and demand deposits came from various issues of Black Enterprise Magazine and FDIC Records. It is pertinent to mention that after 1994, the data for loans and demand deposits are for the 25 largest black-owned banks (financial institutions). This study covers the time period from 1970 to 2001.

Table 1 presents the calculated sign of the regression coefficients for both models of bank behavior--the profit and accommodation principles. The t-values are captured in parenthesis. The two competing theories about bank behavior propose alternative signs for the regression coefficients. For the Profit-Maximizing Hypothesis, the coefficient of the sign for [i.sub.S], is suppose to be positive (+), [i.sub.L] to be negative (-), and GDP/D should have no (o) effect on the demand for loan (L/D). Conversely for the Accommodation Hypotheses, [i.sub.S], is suppose to be negative (-), [i.sub.L] to be positive (+), and GDP/D should be positive (+).

The regression results in Table 1 produced a mixed result. The signs of the coefficients of short-term (+) and long-term (-) interest rates conform to the profit maximizing principles, although, both variables are not statistically significant at the 5 or 10 percent confidence intervals. The coefficient that represents the level of economic (GDP/D), has a statistically negative sign which neither supports the profit or the accommodation principles. The existing empirical evidence tends towards a profit maximization principle. Some will argue that management of these banks is straddling between the two principles. To judge from the results in the table above, as the ratio of GDP/D rises ceteris paribus, by 10 percent per year, loan ratio fall by 3.5 percent. A ceteris paribus rise of one percent rise in the treasury bill rate (short term interest rate), loan ratio decline by .094 percent, conversely, a one percent rise in the long-term interest rate (corporate bond rate) lead to decline of .333 percent in the loan ratio

The coefficient of adjustment (1-[lambda]) which is (1-.464) equal to .536, implying that about 54 percent of the discrepancy between the desired and actual respect to loan ratio is eliminated in one year. The low value of (1-[lambda]), signifies a slower speed of adjustment to close the gap between desired and actual values of loans.

Table 1. Regression Results: Equation (3) (variables
in natural logarithms)

Intercept   [i.sub. S]   [i.sub.L]   GDP/D

-0.699      0.094        -0.333      -0.349 *
(1.768)     (0.841)      (1.506)     (4.466)

-0.195      0.114        -0.237      -0.289 *
(0.600)     (1.317)      (1.380)     (4.686)

Intercept   Lagged     Standard   [R.sub.2]
            Variable   Error

-0.699                 0.172      .46
(1.768)

-0.195      0.464 *    0.133      .69
(0.600)     (4.460)

Numbers in parentheses are the t-values of the regression
coefficients.

* Statistically significant at 5 percent level

REFERENCES

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Black, Harold and Kwast, Myron, "An Analysis of the Behavior of Matured Black-Owned Commercial Banks," Journal of Economics and Business, Vol. 35, No.1, 1983, 41-54.

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Mehdian, S., and Elyasiana, E., "Productive efficiency performance of minority and nonminority-owned banks: A nonparametric approach," Journal of Banking and Finance, Vol. 16, No.5, 1992, 933-948.

William, L. Scott, et al., "Expense Preference and Minority Banking: A Note," The Financial Review, Vol. 23, No. 1, 1988, 105-115.

Dr. Valentine Okonkwo earned his Ph.D. at Florida State University in 1985. Currently, he is a professor of economics/finance and Dean of School of Business at the Kentucky State University, Frankfort.