Academic journal article Economic Perspectives

Competition among Banks: Good or Bad?

Academic journal article Economic Perspectives

Competition among Banks: Good or Bad?

Article excerpt

Introduction and summary

In recent years we have witnessed a substantial convergence of research interest and the opening of a debate on the economic role of market competition in the banking industry. The need for such a debate may seem unjustified at first. The common wisdom would hold that restraining competitive forces should unequivocally produce welfare losses. Banks with monopoly power would exercise their ability to extract rents by charging higher loan interest rates to businesses and by paying a lower rate of return to depositors. Higher lending rates would distort entrepreneurial incentives toward the undertaking of excessively risky projects, thus weakening the stability of credit markets and increasing the likelihood of systemic failure. Higher lending rates would also limit firms' investment in research and development, thus slowing down the pace of technological innovation and productivity growth. Lower supply of loanable funds, associated with higher lending rates, should also be reflected in a slower process of capital accumulation and, therefore, in a lack of convergence to the highest levels of income per capita.

These are some of the conventional effects that market power in the banking industry is commonly thought to generate. However, in more recent years, researchers have begun analyzing additional issues in the matter of bank competition, highlighting potentially negative aspects and so raising doubts regarding the overall beneficial welfare impact of bank competition on the economy. The research effort devoted to this issue has picked up noticeably, a sign that the time is ripe for an open debate regarding the costs and benefits of bank competition. [1]

The policy implications associated with this issue, related to the regulation of the market structure of the banking industry, are especially relevant. In fact, banking market structure is a traditional policy variable for the regulator. Implicitly or explicitly motivated by the desire to restrain banks' ability to extract rents, policymakers would typically recommend measures aimed at fueling competition, promoting the liberalization of financial markets and removing barriers to entry (see, for example, Vittas, 1992). In light of the most recent regulatory changes affecting the U.S. financial industry, the policy relevance for U.S. regulators is more current than ever. In 1992 intrastate branching restrictions were relaxed, followed in 1994 by the passage of the Riegle-Neal Interstate Banking and Branching Efficiency Act, which allows bank holding companies to acquire banks in any state and, as of June 1, 1997, to branch across state lines. Finally, 1999 saw the passage of the Financial Services Modernization (Gramm-Leach-Bliley) Act, allowing the operation of commercial banking, investment banking, and insurance underwriting within the same holding company. Such regulatory changes continue to have a significant impact on the market structure of the banking industry and on banks' competitive conduct. A deeper analysis of the economic role of bank competition should thus contribute to our understanding of the role of the regulator and the consequences of regulatory action and, therefore, support more effective policymaking.

The goal of this article is to summarize some of the arguments that have recently emerged and to suggest some new lines of investigation. In the next section, I describe theoretical contributions that have identified both positive and negative effects of bank competition. Subsequently, I illustrate the results of existing empirical studies, which present mixed evidence regarding the economic role of bank competition. The main conclusion that seems to emerge from the review of the current literature is that the market structure of the banking industry and the related con duct of banking firms affect the economy in a much more complicated way than through the simple association: more market power equals higher lending rates and lower credit quantities. …

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