The Demand for Tax-Exempt Securities by Financial Institutions

Considerable disagreement has developed as to what factors determine the quantities of tax-exempts held by commercial banks and property insurance companies. Several studies, Galper and Petersen [4], Rosenbloom [10] and Silber [11] have argued that the demand by commercial banks is largely determined as a residual. That is, any investible funds in excess of bank reserve, liquidity and loan needs are used to purchase tax-exempts. While not necessarily disputing the importance of such factors, others have found that relative yields on taxable and tax-exempt securities are an important determinant of demand. Fortune [2] and Friedman [3], respectively, allocate bank residual funds and total funds of property insurance companies on this basis. The residual funds theory is not based on profit-maximizing behavior and is clearly inconsistent with observed commercial bank purchases of tax-exempts in 1975 and 1976. The combination of massive reintermediation of deposits and repayment of business loans would have been expected to result in substantial bank purchases. In fact, holdings of tax-exempts increased by less in the two year