A Test of the Law of One Price in Retail Banking

Article excerpt

THIS PAPER USES THE SPANISH retail banking market as a case study to investigate the workings of the Law of One Price (hereafter, LOP). Although economic integration and price convergence has been a topic of interest in international economics (1) and there are several country level studies on price differentiation, (2) we are not aware of a comprehensive analysis of the LOP in retail banking as the one presented in this paper. Research on the level and the time dynamics of dispersion in loan and deposit interest rate has an academic interest since it will extend the existing limited knowledge on the workings of the LOP, as well as a practical one since the findings in one country member will be relevant to shape expectations about the future banking integration in the Euro area.

We take advantage of a large and unique database: quarterly quoted interest rates for 25 different banking products and for each individual commercial and savings bank during the period 1989 to 2003. Thus, we have information about marginal interest rates for both loan and deposit products. Combining different data sources we also obtain credit-risk-adjusted marginal opportunity costs for each loan product at the bank level. These marginal costs prove to be very relevant to explain the dynamics of loan interest rates over time and to obtain the long-term convergence value of the mark up over the marginal cost. In this way, the study of the LOP provides new insights on banking competition. The study starts in 1989 when the restrictions to the geographic expansion of savings banks, now half of the market, were removed and banking liberalization was completed. (3) Between 1994 and 1998 Spain was in a process of nominal convergence to meet the criteria to become a member of the Euro zone (interest rates fell from 15% to 3.5%). Over the period 1999-2003 Spain has been a full member of the Euro zone. Thus, each period offers a different scenario in terms of monetary and competitive conditions under which banks operate, which is worthwhile to study separately.

Interest rate differences will be evaluated under the absolute and the relative versions of the LOP. The absolute version states that products that are close substitutes for the buyers must be sold at the same price within the boundaries of a market. Thus, we want to test whether the products offered by Spanish banks are integrated into a single market (low interest-rate dispersion) or not (high interest-rate dispersion) and whether integration increases or decreases over time. Moreover, we perform an analysis of variance to evaluate, for the first time, how much of the observed dispersion in interest rates can be explained by product, bank, geographic market and time specific effects.

When the absolute version of the LOP does not hold, market integration can still be evaluated through the relative version of the law, which focuses on the dynamics of prices. Now, the LOP is said to hold when the null hypothesis that relative prices follow a random walk is rejected in favor of the alternative hypothesis of long-term price convergence (Asplund and Friberg 2001). The existence of a random walk implies that a new shock that widens the differences across relative prices persists over time and is not eliminated. On the other hand, price convergence implies that price dispersion can be a transitory phenomenon and the speed of convergence can be used as a measure of more or less adherence to the law. In our case, we will test whether a shock that widens the differences of interest rates with respect to their respective marginal cost (i.e., a shock in the markup) is persistent or it fades away over time and at what speed. Since the evaluation of high or low speed depends on the benchmark chosen, the paper examines if the speed increases or decreases over time within the 1989-2003 period, which includes years before and after Spain joined the Euro area.

The paper extends the analysis of interest rate convergence to the evaluation of banking competition. …