Ebook Market Power And Bank Interest Rate Adjustments
The speed and symmetry of price adjustments to changes in market conditions or to macroeconomic shocks affect economic efficiency since there may be missal location costs when prices are not in equilibrium. Price rigidity has been related to market structure [Means (1935), Hall and Hitch (1939)] and, more recently, to costs faced by firms when they change prices. The costs can be direct, for example menu costs [Rotemberg (1982); Rotemberg and Saloner (1986); Benabou and Gertner (1993)], or indirect when firms face quantity adjustment costs [Ginsburgh and Michel (1988); Pindyck (1993), (1994); Borenstein et al. (1997)]. Fixed or variable costs at changing prices, together with a price inelastic demand for the product, cause changes in the profit maximizing prices to lag behind changes in production costs. One important piece of research is to study the effect of market power on the price adjustment speed [Carlton (1986)].
In the case of loan and deposit interest rates, the flexibility in the adjustments to changes in the money market interest rate determines the effectiveness of the monetary policy and the relationship between money supply and aggregate output. Research on interest rate rigidity using bank level data started in the US with papers such as Hannan and Berger (1991), Neumark and Sharpe (1992) and Hannan (1994) on deposit interest rates; and Ausubel (1989) and Calem et al. (1995) on credit card loans. More recent pieces of work focus on European countries, such as Hofman and Mizen (2004) for the UK, Gambacorta (2004) for Italy, Weth (2002) for Germany and De Graeve et al. (2004) for Belgium.
This paper develops a microeconomic analysis of price rigidity in loan and deposit markets to changes in the money market interest rate. Unlike Hannan and Berger (1991), which carries out a menu cost analysis, we do so allowing for adjustment costs in the quantity of loans and deposits [Flannery (1982)]. The empirical study uses annual interest rates, quoted on a monthly basis by individual Spanish banks, of four loan and four deposit products. In this period, nominal money market interest rates evolved from a high level of 15% in 1989 to a low rate around 3% in 2003. Our research questions include the magnitude and stability of the adjustment speed over time, its symmetry to an increase or a decrease in the money market interest rate, differences across bank products and the relationship between price rigidity and variables associated with market structure and behaviour of banks, such as market concentration, demand growth and price collusion.
As one of its relevant contributions, this paper contains a thorough discussion of the relationship between market power and the price adjustment speed under supply adjustment costs (versus direct price adjustment costs) and under alternative market structures and behaviour of banks. Theoretical results show that, when price adjustment costs are direct (for example menu costs), factors that lower bank market power (such as the deposit supply and loan demand slopes) increase the price adjustment speed. In this situation, conditions that favor higher bank market power also increase interest rate rigidity. However, when costs of changing interest rates are indirect (for example quantity adjustment costs), the relationship between market power and price rigidity is more ambiguous and higher market power can be associated with higher or lower speed in price adjustment.
This paper studies interest rate rigidity in loan and deposit products of different maturity using bank level data and actual interest rates charged by Spanish banks that represent over 90% of the Spanish retail banking industry. Unlike deposits, loan markets are affected by information asymmetries between borrowers and lenders that result in adverse selection and credit rationing [Stiglitz and Weiss (1981)]. Although much less is known about it, credit rationing may create interest rate rigidity even in the absence of adjustment costs, especially in response to upward changes in the interest rates [Berger and Udell (1992)]. The study is performed under a unified framework for both types of bank products and considering that price rigidity can be the result of quantity adjustment costs. Previous work with bank level data in the US has concentrated mainly on interest rate rigidity for deposits and focused on loans only in particular cases, such as credit cards. Moreover, the underlying theory is not always outlined in detail, especially in some papers [such as Neumark and Sharpe (1992)] that make no explicit distinction between predictions from menu and supply adjustment costs.
Papers on interest rate rigidity in other European countries are mostly concerned with banks characteristics that affect price rigidity within the broader topic of interest rate transmissions after monetary policy decisions. Papers that also use bank level data, such as De Graeve et al. (2004), study prime rates fixed by banks but not the actual interest rates at which transactions are made. As for this paper, it uses actual interest rates charged by banks in both loans and deposits and it is mainly concerned with the effects of market structure, instead of bank characteristics, on interest rate rigidity. Finally, the long period of time covered by the data permits to analyse the stability of the adjustment speed over time and evaluate the results in terms of the effects of introducing the Euro as a single European currency.
Overall, this paper is inspired by the Industrial Organisation tradition where market performance is associated, in a negative way, with relative profit margin (as measuring market power) and, positively, with price adjustment speed. Higher relative profit margin implies higher dead weight losses and therefore, it can be considered as an inverse measure of static efficiency. A higher price adjustment speed shall be an attribute of market flexibility and lower misal location costs, and then it can be associated with dynamic efficiency. Both market power and the speed of price adjustment are endogenous variables that depend on the market structure, the behaviour of banks and the nature of the adjustment costs. Therefore, the empirical study of the interest rate adjustment over time will be highly informative about the evolution of market power of Spanish banks.
Our results give evidence for substantial and non-symmetric rigidity in Spanish interest rates, although the actual adjustment speed varies across products. We also find that the non-monotonic response of the adjustment speed to market concentration is consistent with an oligopolistic market structure where banks face quantity adjustment costs in loans and deposits. Loan interest rate rigidity is lower among commercial banks than among savings banks, but no difference is observed between both types of banks in case of deposits. Larger banks show higher interest rate rigidity than small banks, but the effect of size is consistently statistically significant only in loans. Interest rate rigidity is higher in markets with higher population growth and the economic significance of the effect of market growth on price rigidity is higher in deposits than in loan products. The Euro has not altered the basic pattern of interest rate rigidity in loans and deposits.
The paper is structured as follows. Section 2 presents the conceptual framework under which we study interest rates rigidity and its determinants. In section 3 we present the data and the methodology used; section 4 contains the empirical results from the estimation of models that measure and explain interest rate adjustments to changes in the money market interest rate; finally, section 5 presents a discussion of the main results and conclusions.
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