4-3 Suppose interest rates on residential mortgages of equal risk were 7 percent

Question

4-3 Suppose interest rates on residential mortgages of equal risk were 7 percent in California and 9 percent in New York. Could this differential persist? What forces might tend to equalize rates?
Would differentials in borrowing costs for businesses of equal risk located in California and New York be more or less likely to exist than differentials in residential mortgage rates? Would differentials in the cost of money for New York and California firms be more likely to exist if the firms being compared were very large or if they were very small? What are the implications of all this for the pressure now being put on Congress to permit banks to engage in nationwide branching?

Explanation / Answer

Could this differential persist? What forces might tend to equalize rates?

If there were no market imperfections, the differential could not persist. However, if for example, there were a law which allows individuals to get mortgages only from banks in their state, the differential could persist for some time. On the demand side of the market, individuals living in New York may be willing to pay a premium for taking a loan from a local bank - this would also encourage the differential to persist.
If such market imperfections do not exist, individuals would turn to California mortgages and away from New York mortgages hoping to get a lower rate. Therefore, demand for New York mortgages falls, and demand for California mortgages rises. individuals pis up the price (rate) on the mortgage in California as the New York mortgage rate falls until the differential disappears

money flows till it is equal for equal risk

Commercial banks are regulated by the Banking Act and include nationwide banks, regional banks, and branches of foreign banks. Nationwide banks have branch networks throughout the entire country and primarily engage in deposit taking, lending, and payment and settlement. They also handle trusts and securities to a limited extent.

Unlike nationwide banks, regional banks operate primarily within the provinces where they are based, and their major customers are small and medium-sized enterprises. They engage in many of the same businesses as nationwide banks, but their foreign exchange operations, including foreign currency deposit taking and loan making, are on a much smaller scale in terms of both absolute volume and shares of total bank operations.

In the past, the branches of foreign banks were allowed to pursue only wholesale banking, while domestic banks were engaged in both wholesale and retail banking. This restriction was eventually lifted, and the branches of foreign banks are now expanding into retail banking and rapidly increasing their shares in the domestic market.

Specialized banks were established to raise financial resources for special industrial needs. They accommodate the financial needs of specific industries that cannot be met by commercial banks due to limited resources or low profitability. The Korea Development Bank, for example, offers long-term facility investment funds to major industries in Korea, while the Export-Import Bank of Korea offers export loans and trade finance. Specialized banks have more channels of financing at their disposal than commercial banks, including bond issuance and government assistance in addition to traditional deposit taking.

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