Abstract

The Optimal Banking Structure: Theory and Evidence from the United States

The optimal banking structure is one in which banks determine, meet and even anticipate the public’s demands at the least cost for a given level of quality. For the economy, the optimal structure is one in which the public’s demands are met with the most efficient expenditures of resources. A competitive market structure, free from government subsidies, penalties and regulations meets these criteria. For competitive markets to operate optimally, the following conditions must obtain: entry and exit (via mergers, acquisition or failure) should be unrestricted, and cartels and natural monopolies should not occur. The extant empirical evidence from the United States is considered to determine the extent to which these conditions apply to the banking industry. Economies of scale are considered first because, if the banking industry is characterized by significant and continuous economies of large scale operations, eventually only one bank would survive under free competition. The studies of the operations costs of commercial banks and savings and loan associations reviewed report statistically significant but not very great economies of scale: a 100 percent increase in output is associated with a 93 percent increase in costs. Thus, small banks appear less efficient than large banks, but the cost advantage of larger size diminishes fairly rapidly. Although data on giant banks were not included in the studies, the analyses reported and the experience in states such as California indicate that free competition should not lead to the dominance of the market by one or a few very large banks as a consequence of operating economies of scale. It would seem, then, that the authorities should permit mergers except where these substantially reduce competition. But competitive markets are difficult to define operationally. Since the authorities usually rely on concentration ratios to measure competition, the extent to which a greater number or lesser dominance of banks in a market is associated with greater benefits to the public should be considered. Evidence is reviewed on the effect of concentration on interest rates for loans, service fees for demand deposits, and interest paid on time deposits. Most of the studies on loan interest rates are so poorly structured that no conclusions can be accepted. Those studies that are useful indicate slightly higher interest rates on loans in areas where there are few financial institutions, or dominance by two or three.banks. Service charges on deposits also appear to be higher and interest paid on time deposits lower in areas where competition is reduced. But the evidence is weak. Since the evidence does not indicate that more than a few institutions are necessary for competitive conditions to exist, the authorities need not be overly concerned that mergers usually will reduce competition. To determine the benefits from a liberal merger policy, the motivation of banks to merge with or acquire other banks is considered. Studies reveal that savings in operatıng costs do not appear to have been a motive for or result of mergers or acquisitions of banks by holding companies. They also reveal that merged and acquired banks tend to serve the public better by offering more loans and service. Mergers that affect competition differently for different classes of customers and mergers of banks that do not presently compete also are discussed. It is concluded that the effect of mergers on local and smaller customers should be given precedence and that prohibition of mergers that reduce potential competition is not usually based on valid reasoning. The keystone to the effective operation of competitive markets is free entry. Barriers to entry are considered. Economic barriers are found to be slight and regulatory barriers great. Analysis shows that the rationale behind government restrictions on entry into banking is based on outmoded considerations. Fear of destructive competition, overbanking and bank failure are not valid. To the contrary, a considerable body of evidence shows that new entrants to banking markets improve prices and service to the public with no evident adverse effect on the safety of existing institutions. Thus, the authorities should allow and encourage entry into banking markets via new banks, branching, and expansion of banking powers to allow other institutions to serve the public