FRBSF Economic Letter
2003-31; October 24, 2003
Good News on Twelfth District Banking Market Concentration
As the banking industry has consolidated in recent years, the
number of banking organizations in the U.S. and in the Twelfth Federal
Reserve
District has declined dramatically. This consolidation trend raises public
policy issues because of its implications for concentration and therefore
competition in local banking markets. Specifically, mergers between banks
in the same local market increase local banking market concentration,
which, in some instances, can weaken competition. To some degree, market
forces work to keep a local banking market from remaining highly concentrated
for too long: other banks tend to move into concentrated markets to seize
the potential pricing advantages, and as they do, concentration declines.
In addition, antitrust enforcement, carried out in part by the Federal
Reserve, helps limit increases in concentration in local markets due
to mergers.
This Economic Letter discusses what has happened to local banking market
concentration in the Twelfth District over the last 18 years. In urban
markets, concentration has not increased too much, and, in rural markets,
it has declined. Although concentration has increased appreciably within
urban or rural markets in some individual states, concentration should
eventually decline in those areas, as their enhanced potential for profits
attracts the entry of new banks.
Why look at concentration?
Concentration measures the degree to which
a market is dominated by just a few firms. Increases in concentration
tend to decrease competition,
leaving consumers facing poorer service, higher fees, higher loan interest
rates, and lower deposit interest rates. Theoretically, in highly concentrated
markets, dominant firms can increase their profits by engaging in strategic
behavior such as price leadership; this would be impossible in a perfectly
competitive market. The link between concentration and competition in
banking also has an empirical foundation. In research based on data from
the 1980s, Berger and Hannan (1989) found that, after controlling for
other factors that might affect the results, deposit interest rates tended
to be lower in metropolitan areas where the banking industry was relatively
concentrated. Using data on loan rates from 20 cities in 1987 and 1988,
Rhoades (1992) similarly found that mortgage interest rates tended to
be higher in cities where concentration was relatively high. Finally,
based on data from 1975 to 1998, Pilloff and Rhoades (2002) found that
local market concentration is positively and significantly related to
bank profitability. But, based on analysis conducted at the Federal Reserve
Bank of San Francisco, it appears that it is mainly among highly concentrated
markets that increases in concentration have a statistically significant
effect on profitability.
What influences concentration?
Mergers are an important influence on
concentration. The banking industry saw tremendous consolidation between
1984 and 2002, with the number of
independent bank and thrift organizations in the U.S. falling by almost
half, from about 15,000 to about 8,000.
From a public policy perspective,
a key concern is the impact of mergers on concentration in local banking
markets. A local urban banking market
typically encompasses a metropolitan area, while a local rural market
encompasses a number of rural communities that are economically linked.
Survey evidence on where people do their banking and research linking
local banking market concentration and prices suggest that, despite technological
advances that have enabled retail customers to bank at a distance, they
still largely get their banking services from local banks.
How do we assess
the effects of mergers on concentration in local banking markets? The
enforcement of antitrust statutes regarding changes in concentration
in local banking markets resulting from mergers uses a measure of concentration
called the Herfindahl-Hirschman index (HHI), which is the sum of the
squares of the individual percent market shares of all the participants
in a market. For example, a market consisting of four firms with market
shares of 30%, 30%, 20%, and 20%, has an HHI of 2,600. This is a rather
high HHI, but not unheard of in rural areas. Given the number of firms
in a market, the HHI is at its minimum when all the firms have equal
market shares. By itself, a merger between two banks operating in the
same local market increases concentration. Using the above example, a
merger between the two banks with 20% market shares would increase the
HHI from 2,600 to 3,400.
Enforcement of antitrust statutes by the Federal
Reserve, the other banking regulators, and the Department of Justice
(DOJ) limits increases in concentration
due to mergers. The DOJ divides the spectrum of market concentration
into three roughly delineated categories that can be broadly characterized
as unconcentrated (HHI below 1,000), moderately concentrated (HHI 1,000-1,800),
and highly concentrated (HHI above 1,800). With respect to bank mergers,
the DOJ's merger guidelines say that if the change in the HHI in any
local market would be greater than 200 and the post-merger market would
have an HHI of at least 1,800, then the merger could "create or
enhance market power or facilitate its exercise." Changes smaller
than 200 points are deemed to be, in general, of little economic significance.
When
the guidelines are exceeded, the regulatory approval of a merger may
require divesting some of the branches of the acquiring and/or the
target bank in the affected local markets to a third party in order to
make the resulting changes in concentration and post-merger concentration
levels acceptable. At the same time, even if the merger breaches the
guidelines, mitigating factors may argue for approval in a particular
market. For example, the relevant market may have faster population growth
than similar markets in the state, indicating the likelihood of a higher
than average increase in the demand for banking services. In such a case,
the market would be expected to attract new entrants at an above average
rate, which would tend to alleviate the increase in concentration due
to the merger.
Factors other than mergers and antitrust enforcement also
influence concentration. For example, during the banking crisis of the
late 1980s and early 1990s,
the number of bank and thrift failures hit the highest levels seen since
the Great Depression. These closures gave an instant boost to the market
shares of the remaining participants, exerting upward pressure on concentration.
Of
course, new banks are continually forming and existing banks are continually
branching into new markets, thus exerting downward pressure on concentration.
For example, according the Federal Deposit Insurance Corporation, the
average annual rate at which the commercial banking industry added new
charters between 1984 and 2002 was about 1.5%. And the number of commercial
bank branches grew about 31% between 1984 and 2002. In some local markets,
the total number of depository institutions has even increased. Natural
population growth may have encouraged the opening of new banks and branches,
given that banks and branches have minimum sizes at which they can be
profitable.
What happened to concentration in the Twelfth District overall?
The trend
in bank consolidation has been clear in the Twelfth District. Between
1984 and 2002, the number of bank and thrift organizations operating
in the District declined from 1,090 to 574.
Given the link between local
market concentration and competition, the consolidation in the District,
and the various influences on concentration,
it is important to investigate what actually has happened to concentration
in local banking markets in the Twelfth District.
As it turns out, on
balance, increases in concentration in Twelfth District urban markets
have not been very large, and concentration in rural markets
actually has declined slightly. In the 62 defined Twelfth District urban
markets, the median local market HHI increased 167 points, from 1,398
to 1,565 between 1984 and 2002. So, at the median, urban markets in the
Twelfth District remained moderately concentrated. In the 97 defined
rural markets, the median HHI decreased 61 points, from 2,273 in 1984
to 2,212 in 2002.
The picture does vary some among the states
Median concentration in urban
and rural markets in some individual states did increase more than 200
points to a level above 1,800. Figure 1 shows
median urban market HHIs for the individual states and the District,
with states and the District ranked by the percent increase in the median
urban market HHI (descending order); Figure 2 shows the analogous statistics
for rural markets. At the median, HHIs in urban markets in Utah, Alaska,
and Arizona increased by more than 200 points to a level above 1,800;
HHIs in rural markets in Hawaii, Oregon, Washington, and Utah also did
so.
Theoretically, market forces should impose a kind of "self-correcting" mechanism
on concentration, implying that concentration should not rise inexorably.
When concentration rises, profitability rises, and this should attract
new entry, thereby decreasing concentration. Figure 3, which presents
a scatter plot depicting changes in concentration between 1984 and 2002
vs. concentration in 1984 for the local banking markets in the Twelfth
District, supports the theory. It suggests that when concentration is
high enough to begin with, it does tend to be followed by decreases in
concentration in the long run; moreover, the higher the initial concentration,
the larger the decreases. (Because antitrust enforcement tends to limit
increases in concentration due to mergers for highly concentrated markets,
but not for unconcentrated markets or most moderately concentrated markets,
antitrust enforcement likely also contributes to the downward sloping
relationship seen in Figure 3.)
The theory is further supported by statistical
analysis which finds that the linear relationship derived from the
data and shown in Figure 3 is
statistically significant not only for Twelfth District local markets
as a whole but also for urban and rural subsets of Twelfth District
local markets. (Rhoades (2000) obtains a similar result for the country
as
a whole.) The tendency for high initial concentration to be followed
by decreases in concentration likely also explains why District urban
markets saw a concentration increase and rural markets saw a concentration
decrease over the last 18 years--namely, rural markets were more concentrated
to begin with.
Finally, the theory is borne out when we look across
groups of states that had larger or smaller increases in concentration
than the District
as a whole. For example, consider urban markets in states that had
a larger increase in concentration than the District as a whole (i.e.,
states to the left of the District in Figure 1). The median 1984
HHI for these markets was 1,322, compared with 1,406 for urban markets
in
states that had a smaller increase in concentration. Next, consider
rural markets in states that had a larger increase in concentration
than the
District as a whole (i.e., states to the left of the District in
Figure
2). The median 1984 HHI for these markets was 2,159, compared with
2,406 for rural markets in states that had a smaller increase in
concentration.
Conclusion
The net result of various influences on concentration in local
banking markets over the past 18 years has been a modest increase in
concentration
for Twelfth District urban markets and a decrease in concentration
in rural markets. Although urban or rural markets in some individual
states
do present exceptions to the overall Twelfth District results,
with relatively large changes in concentration to relatively high
levels,
these regions
should show declines in concentration in their turn.
Liz Laderman
Economist
References
Berger, Alan, and Timothy Hannan. 1989. "The Price-Concentration
Relationship in Banking." Review of Economics and Statistics 71
pp. 291-299.
Pilloff, Steven J., and Stephen A. Rhoades. 2002. "Structure
and Profitability in Banking Markets." Review of Industrial
Organization 20 pp. 81-98.
Rhoades, Stephen A. 1992. "Evidence on the Size of Banking Markets
from Mortgage Loan Rates in Twenty Cities." Federal Reserve
Bulletin 78 pp. 117-118.
Rhoades, Stephen A. 2000. "Bank Mergers and Banking Structure in
the United States, 1980-98." Board of Governors of the Federal Reserve
System Staff Study 174.
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