This review combines recent findings from the empirical banking literaturewith established insights from studies of banking competition and regulation. Motivated by modern theory of financial intermediation we center our review on the different sources of bank rents. “Sailing this tack” ensures that we don’t replicate the many excellent reviews on financial intermediation that also feature discussions of the various aspects of competition in the banking sector.
We start with a concise overview of the different methodological approaches taken to address competition in general and banking in particular. Our review of the traditional and new empirical methods employed in Industrial Organization (IO) is brief, specifically applied to banking, and mostly illustrative. We first discuss the traditional studies of Structure-Conduct Performance, bank efficiency, and economies of scale and scope. Then we turn to the New Empirical IO approaches taken by Panzar and Rosse (1987), the conjectural variations, structural demand, and other structural models (sunk costs and entry). We highlight the strengths and weaknesses of these different approaches and are naturally drawn to focus on the differences in data requirements and treatment of endogeneity in each method.
Figure 1 shows how research on banking competition has evolved over time. The figure highlights that since the early 1990s a sea change took place in modeling competition, measuring concentration and conduct, and arriving at fruitful applications. The literature basically abandoned the traditional Structure-Conduct-Performance paradigm stating that banks in less concentrated markets behave less competitively and capture more profits.
The literature has pushed in two directions since. One strand of the literature embarked on modeling market structure as endogenous. We will review this part of the literature in Section II. A second push in the literature intended to capture the “special nature of banking competition” by also looking at non-price dimensions of banking products. Theoretical work tackled for example the availability of credit and the role bank-firm relationships play in overcoming asymmetric information problems. Consequently in Sections III to VI we structure our discussion of the empirical findings in the literature based upon a framework that finds its roots within the different theories of financial intermediation (see the companion paper by Carletti (2005) reviewing the theoretical banking competition literature). We categorize and assess the many empirical findings in the literature on competition in banking by distinguishing between four possible sources of bank rents: market structure, switching costs (includes informational rents), location, and regulation.
Market structure consists for example of the number of players in the market but may also refer to the existence of alternative providers of finance. Switching costs can be the fixed technical costs of switching banks existing in retail deposit markets but can also be the costs of engaging a new bank rooted in pervasive informational asymmetries in business loan markets. Location stands for both distance and borders (see also Degryse and Ongena (2004)). We think of distance as pertaining to physical proximity that can be bridged by spending distance-related costs. For a given location of bank and borrower, distance per se is exogenous and bridging it (i.e., the lender visiting the borrower and/or the borrower visiting the lender) may be adequate to reduce informational problems for the lender concerning its decision about granting and pricing the loan. Borders introduce a “discontinuity”: borders endogenously arise through the actions of the competing lenders or result as an artifact of differences in legal practice and exogenous regulation (Buch (2002)). In addition to differentiating between the sources of rents, we further frame our discussion by distinguishing between conduct and strategy. Conduct comprises the offering, pricing and availability of loans and/or deposits, while strategy concerns market presence and structure, and deals with the entry, location, composition and heterogeneity in bank (branches) present in the market.
