The Changing Role of Commercial Banks in the Municipal Securities Market

The tax treatment of commercial banks as investors in municipal securities changed dramatically with the loss of interest expense deductibility for municipal carrying costs under the Tax Reform Act of 1986. Competing theories of relative yield determination suggest that the lost deductions and recent reductions in corporate and personal tax rates should have different effects on the ratio of municipal to taxable yields. This study examines the empirical implications of these tax changes using time series for the period 1966-1992. Results suggest that the yield ratio varied inversely with relative bank purchases of municipals through mid-year 1986. After 1986, however, increased bank municipal purchases no longer directly lowered relative municipal yields. The yield ratio also varied inversely with changes in personal tax rates throughout the sample period, and increased after 1986 when banks lost 100 percent of their interest deduction for municipal carrying costs. Changes in corporate tax rates apparently play little role in shaping relative yields. Copyright 1995 by Ohio State University Press.