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Economic Review

Economic Review
March/April 1996, Volume 81, Number 2

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1 Banks' Responses to Binding Regulatory Capital Requirements

Larry D. Wall and
Pamela P. Peterson

Since the early 1980s U.S. bank regulators have focused increasingly on the adequacy of banks' capital ratios. This article begins with a review of the changes to U.S. capital regulations and theoretical models for determining banks' capital strategy. The authors then survey numerous studies that examine banks' responses, and the costs associated with their responses, to these regulations.

The authors categorize banks' responses into two primary types. The first of these, termed cosmetic changes to the capital ratio, may be achieved in one of two ways: a bank may reduce its total assets while increasing the proportion of risky assets, or it may exploit differences between capital as measured for regulatory purposes and the bank's true economic capital. Such cosmetic changes may bring a bank's capital ratio within regulatory guidelines without reducing either the probability that the bank will fail or the losses to depositors and the deposit insurance agency if the bank fails. The second general type of response a bank may make to capital regulation is to effectively increase its capital cushion by either reducing its risk exposure or increasing its capital levels.

The authors point out that regulators need to consider what response they want to elicit when formulating new regulations. If the regulations are being imposed to reduce the risk of a systemic problem and the expected losses of the deposit insurance agency, then regulations that encourage cosmetic responses are, by definition, unlikely to accomplish regulatory goals. The authors also note that the best way to reduce a bank's riskiness in many cases--diversification and hedging--is not adequately recognized under current capital standards.

18 Do State and Local Taxes Affect Relative State Growth?

Zsolt Becsi

The South has seen a remarkable economic rise during the past three decades. Was this growth a result of automatic forces or was it fueled by state and local tax policies? Traditional economic theory suggests that forces of convergence, not tax policies, have moved the southern states toward catching up with the rest of the nation. But more recent economic models recognize that convergence and low tax rates may not be mutually exclusive explanations for the South's stronger growth.

This article presents an overview of relative state growth and relative state and local taxation from 1960 to 1992. After a brief discussion of the theoretical issues, the article surveys simple--but revealing--correlations across states and across time that characterize states' experiences. The correlations indicate convergence but also imply that shocks, including tax policy, matter for long-term growth.

The author argues that the evidence on the growth effects of taxes has been mixed because empirical models imperfectly separate the growth effects of other government policies that occur simultaneously with tax policies. He demonstrates a simple way to get a more nearly accurate specification. His analysis shows that state and local taxes appear to have temporary growth effects that are stronger over shorter intervals and a permanent growth effect that does not disappear.

In terms of policy implications, if long-term growth rates seem too low relative to other states, lowering aggregate state and local marginal tax rates is likely to have a positive effect on long-term growth rates. However, such a policy also reduces the progressivity of the tax system. No matter what emphasis is placed on growth, states should be aware of the potential trade-off.

37 FYI -- Tracking Manufacturing: An Update on the Survey of Southeastern Manufacturing

R. Mark Rogers

In late 1991 the Atlanta Fed's research department launched the first comprehensive survey to focus solely on indicators of manufacturing activity in the Southeast. Because the manufacturing sector is more cyclical than most other sectors, the Survey of Southeastem Manufacturing Conditions has been helpful in tracking the region's economy.

This article revisits the survey, examining in particular the implementation of seasonal adjustment procedures in March 1995. The seasonally adjusted data make time series comparisons easier and thus provide a clearer picture of past and current conditions and manufacturers' expectations. After briefly describing the makeup of the survey, the author describes the seasonal adjustment process and then reports the trends, conditions, and expectations in the manufacturing sector tracked by the survey since its inception.

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The Economic Review of the Federal Reserve Bank of Atlanta presents analysis of economic and financial topics relevant to Federal Reserve policy. In a format accessable to the nonspecialist, the publication reflects the work of the Research Department. It is edited, designed, produced, and distributed through the Public Affairs Department.

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ISSN 0732-1813