Ebook Compositional Dynamics and the Performance of the U.S. Banking Industry
Studies of longitudinal data for U.S. manufacturing plants reveal enormous heterogeneity across plants and highlight the importance of the changing composition of firms within an industry. A substantial portion of industry-wide productivity gains, for example, reflect the reallocation of output from low to high productivity plants, rather than productivity gains at individual plants. Since these reallocation effects are often interpreted as the benefits of the competitive process as plants innovate, adapt, and fight for survival, separating reallocation effects from plant-level gains provides valuable information about the factors driving changes in industry performance.
Reallocation effects, however, have been noticeably absent from studies of the U.S banking industry despite a long history of longitudinal research. The banking studies typically focus on microeconomic questions such as economies of scale or scope, input substitution, and frontier efficiency, while ignoring the aggregation and composition issues so common in the manufacturing literature. This omission is particularly surprising given the enormous heterogeneity across U.S. banks and the massive reallocation of resources associated with steady consolidation in the 1980s and 1990s. These two facts suggest a large impact from reallocation effects in U.S. banking.
This paper fills the research gap by quantifying how dynamic reallocation effects contribute to the performance of the U.S. banking industry as a whole from 1976 to 1998. Building on tools developed in the manufacturing studies, I present a novel decomposition framework that accounts for consolidation dynamics unique to banks. The decomposition identifies and measures two broad factors that jointly determine the performance of the U.S. banking industry: “within effects” due to changes in surviving banks and “reallocation effects” due to market share changes, entry, and exit. By focusing on bank-level results and the corresponding aggregation issues, this analysis provides new insights into the impact of competition and the evolution of U.S. banking.
The results show changes in the performance of surviving banks determine industry trends, but dynamic reallocation effects also make important contributions to changes in industry profitability and capital adequacy. When overall industry profitability increased, for example, about three quarters of industry-wide gains were due to increased profits at individual banks. The remaining gains reflect dynamic reallocation effects as market share shifted from low to high profit banks. In periods of declining profits, however, reallocation effects remained positive and increased in size. This resource reallocation improved industry performance as the strongest commercial banks grew in relative size, while the weakest exited the industry.
Variation in the reallocation effects over time also provides a new perspective on the impact of the competitive process. When consolidation and deregulation accelerated in U.S. banking during the late 1980s and early 1990s reallocation effects increased dramatically, implying that industry restructuring made substantial contributions to gains in industry profits. The late 1990s, however, are markedly different reallocation effects were consistently negative after 1995 as changes in bank size and profitability were negatively correlated on net. While surprising, this finding is consistent with the casual observation that many large bank mergers in recent years have not improved performance. These results show resource reallocation in the late 1990s actually lowered industry profitability.
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