Academic journal article Journal of Money, Credit & Banking

Banks' Responses to Deregulation: Profits, Technology, and Efficiency

Academic journal article Journal of Money, Credit & Banking

Banks' Responses to Deregulation: Profits, Technology, and Efficiency

Article excerpt

The deregulation of interest rates in the early 1980s raised bank funding

costs and lowered profits. In response, banks raised fees for deposit

services, reduced branch operating costs, and shifted to higher earning

assets. Rates of return did not regain their prederegulation levels until

the early 1990s.

Our goal is to decompose the change in bank profits following

deregulation into (i) internal, bank-initiated adjustments to the new

regulatory structure and (ii) external, contemporaneous changes in banks'

business environment. This decomposition will depend, in part, on the

assumed competitive structure of the banking industry. With perfect

competition, output and input paces are part of the external environment

and banks' responses are limited to changes in output and input quantities.

An alternative approach assumes imperfect competition where banks have

some control over output prices (deposit fees, minimum balance

requirements, and interest rates on certain loans) and output quantities

and input prices comprise the external environment.

The alternative model is supported by the data. Using this model, large

banks--but not smaller banks--are found to have relied primarily on

changing output prices and input use to mitigate and reverse the negative

effects of deregulation on profits. The adjustment to deregulation was

essentially complete after four years. Following this, additional changes

in bank profitability (during the late 1980s) were primarily due to changes

in banks' business environment.

The interest rate deregulation of the early 1980s sharply raised costs and lowered profits of the U.S. banking industry. Bank-initiated adjustments to deregulation were quite broad and included raising fees for deposit services, reducing operating costs at branch offices, shifting asset mix toward floating-rate loans, and taking on greater asset risk in search of higher revenue. While many of these adjustments were successful in offsetting the deregulation-induced structural increase in bank funding cost, others were not. Profits were stabilized, but at a lower rate than had existed previously, and annual rates of return did not regain their pre-deregulation levels until 1992.

Changes in bank profits following deregulation were influenced by two things: (i) internal, bank-initiated adjustments to the altered regulatory structure and (ii) external, contemporaneous changes in banks' business environment. Our purpose is to separate these two effects and determine both the relative importance of bank-initiated adjustments as well as the length of the adjustment period. This task is complicated by the fact that the measurement of both bank adjustments to deregulation and changes in external environment will depend on assumptions about the nature of the overall competitive structure of the banking industry. The standard methodology assumes perfect competition, where output and input prices are part of the external environment, and banks' responses are limited to choices among output and input quantities. An alternative approach, which we embrace, views banks as exercising some degree of control over output prices. Here the external business environment (that is, the exogenous variables in the induced indirect profit function) consists of input prices and banking output quantities, which are measured more completely than output prices. Under this scenario banks adjust to the changing regulatory and business environments through choices among output prices and input quantities.

In truth, the current structure of the banking industry lies somewhere in between. Banks exploit local market power in setting deposit fees, minimum balance requirements, and interest rates on consumer, small business, and middle-market corporate loans. …

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