Academic journal article Economic Perspectives

Entry and Competition in Highly Concentrated Banking Markets

Academic journal article Economic Perspectives

Entry and Competition in Highly Concentrated Banking Markets

Article excerpt

Introduction and summary

What determines the number of banks operating in a market? What is the relationship between the number of banks in a market and competitive conduct? These are important questions, whose answers define the industrial organization characteristics of a banking market. They are also questions of fundamental policy relevance for antitrust regulation.

In this article, I address these questions by focusing specifically on very highly concentrated banking markets. I focus on these markets because this is where we would expect to observe the least competitive conditions. Indeed, if there is any likelihood of establishing and maintaining a cartel, where firms explicitly or tacitly collude in order to behave as one monopolist, it will be in markets with the fewest firms. It is in these markets, therefore, that firms should be able to impose the highest mark-ups; and, by definition, these markets should raise special antitrust concerns in the event of a merger application. How anticompetitive are highly concentrated banking markets? Is there any evidence of actual collusive behavior? Also, how quickly do markets approach a competitive benchmark, that is, how many additional entrants does it take before we observe higher degrees of competition?

Answers to these questions contribute to the policy debate on competitive conditions in the banking industry and provide information on the current practice for assessing market competition in merger analysis. As is widely known, the procedures to evaluate the competitive impact of merger proposals require an evaluation of the concentration of deposit market shares held by banks operating in the market affected by the merger. According to the so-called structure-conduct--performance paradigm (Bain, 1951), one would expect to observe increasingly anticompetitive conduct where market shares are more concentrated. Market concentration is commonly measured by the Herfindahl-Hirschman Index (HHI), which is defined as the sum of the squared market shares of all banks in the market. The HHI index is bounded from below at zero in the (hypothetical) case of a very large number of extremely small banks and bounded from above in the other extreme case of a monopolist, where the index would then be equal to [100.sup.2] = 10,000. According to the current guidelines for antitrust analysis in banking, if a merger brings a market HHI above the value of 1,800, it has the potential for anticompetitive consequences, thus triggering further analysis before approval. In other words, any market with an HHI above 1,800 is considered highly concentrated and, therefore, more likely to be characterized by anticompetitive conduct. To have a better idea of how an HHI around 1,800 translates in reality, consider that a market with five banks, each controlling an equal share of the deposits market, has an HHI equal to [20.sup.2] + [20.sup.2] + [20.sup.2] + [20.sup.2] + [20.sup.2] = 2,000. As I show below, the average HHI across all the markets I analyze in this article is about 4,000, and 90 percent have an HHI greater than 1,800. Hence, the focus of this article is exactly on the markets that raise special antitrust concerns.

How can we evaluate competitive conduct in such highly concentrated markets? What we would like to measure is what Sutton (1992) defines as the toughness of price competition, that is, by how much market prices vary as the number of competing firms increases. If it is really the case that incumbent firms collude and maximize joint monopoly profits, then the entry of an additional firm would not have any effect on prices. This extreme model features the least intense level of competition (really the lack thereof) and thus represents a good benchmark against which to compare actual market behavior. Any other model of competition will typically assume some price response by incumbents to the decision of an additional firm to enter the market. …

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