Academic journal article Economic Perspectives

Competitive Analysis in Banking: Appraisal of the Methodologies

Academic journal article Economic Perspectives

Competitive Analysis in Banking: Appraisal of the Methodologies

Article excerpt

Introduction and summary

Over the last 20 years, the U.S. banking industry has experienced significant structural changes as the result of an intense process of consolidation. From 1975 to 1997, the number of commercial banks decreased by about 35 percent, from 14,318 to 9,215. Since the early 1980s, there have been an average of more than 400 mergers per year (see Avery et al., 1997, and Simmons and Stavins, 1998). lhe relaxation of intrastate branching restrictions, effective to differing degrees in all states by 1992, and the passage in 1994 of the Ricgle-Neal Interstate Banking and Branching Efficiency Act, which allows bank holding companies to acquire banks in any state and, since June 1, 1997, to open interstate branches, is certainly accelerating the process of consolidation.

These significant changes raise important policy concerns. On the one hand, one could argue that banks are merging to fully exploit potential economies of scale and/or scope. The possible improvements in efficiency may translate into welfare gains for the economy, to the extent that customers pay lower prices for banks' services or are able to obtain higher quality services or services that could not have been offered before.(1) On the other hand, from the point of view of public policy it is equally important to focus on the effect of this restructuring process on the competitive conditions of the banking industry. Do banks gain market power from merging? If so, they will be able to charge higher than competitive prices for their products, thus inflicting welfare costs that could more than offset any presumed benefit associated with mergers.

In this article, I analyze competition in the banking industry, highlighting a very fundamental issue: How do we measure market power? Do regulators rely on accurate and effective procedures to evaluate the competitive effects of a merger?

The U.S. Department of Justice, the Federal Reserve System, the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC) enforce the antitrust laws in banking. The procedures to evaluate the competitive impact of a proposed merger may differ in some details among the agencies, but they all share the same approach, based on structural analysis of the banking market affected by the merger. The basic guideline, established by the Justice Department, requires the evaluation of the concentration of deposit market shares held by banks operating in the affected market. The importance of market concentration finds its theoretical justification in the so-called structure-conduct-performance paradigm (Bain, 1951), which postulates that fewer and larger firms (higher concentration) are more likely to engage in anticompetitive conduct. For example, a small number of large firms may be able to cooperate and act as a monopoly (cartel). Alternatively, one or more firms together may be large enough to set higher than competitive prices (acting as a dominant firm), while the other (smaller) firms would act as a competitive fringe, following the dominant firm's behavior.

The most common measure of concentration, and the one used by regulators, is the Herfindahl-Hirschman Index (HHI), which is defined as the sum of the squared market shares of all banks in the market (box 1 explains how the index is calculated).(2) According to the current screening guidelines, if the postmerger market HHI is lower than 1,800 points, and the increase in the index from the pre-merger situation is less than 200 points, the merger is presumed to have no anticompetitive effects and is approved by the regulators. Should those threshold values be exceeded, the regulators will check for the existence of potential mitigating factors that would make it unlikely that the merger could result in anticompetitive behavior. The regulators also seek to identify those extreme cases in which the potential welfare loss from the exercise of market power would be smaller than the loss produced by maintaining the status quo (for example, the merger might prevent the failure of one of the parties involved, thus preserving the stability of the market). …

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