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France and Spain to be positive and significantly different from both zero and unity. They concluded that in these markets, commercial banks operated in a monopolistically competitive market. However, the authors cautioned that the result is different from the type of contestable market implied by the theory because incumbent banks were not undertaking perfectly competitive pricing. For Italy, the authors could not reject a hypothesis of monopoly or a conjectural variation short-run oligopoly for the years 1987 and 1989 because the PRs were found to be negative, and both were significantly different from zero and unity.

Bikker and Haaf (2002) look at competition in the European banking sector using the PR statistic, and compare their European findings with the USA and other countries.

Perrakis (1991) criticised Nathan and Neave and argued the PR may be inadequate as a test for contestability.38 However, there are more fundamental problems with the use of PR to infer contestability than those raised by Perrakis. There is a potential problem with the timing of the firms’ entry and exit decisions. The computations in the studies cited above implicitly assume there were no lags in interest rate adjustments, so interest rates were contemporary with the change in total revenue, and entry and exit by other firms was very rapid and in the same period.

Additional problems arise from the claim that PR is sufficient or necessary for contestability. If firms have flat-bottomed average costs in a perfectly contestable market, the elasticity of total revenue to the input price vector is (1 − e), where e is the price elasticity of demand if no firm actually enters or quits the market. e could be greater or less than unity, and therefore, PR could be negative, even under conditions of perfect contestability. Furthermore, consider a classic, incontestable Cournot oligopoly. In the Cournot model, as the number of firms increases, the price of the good or service will fall. In a contestable market, there should be no sensitivity to firm entry. Assume Cournot applies, with linear demand and horizontal marginal cost. Then PR will be positive if the given number of firms is large and marginal cost is low. If the statistic can be positive under Cournot, then one cannot claim a positive value of PR as evidence of confirmation of contestability.

Furthermore, given the banks’ ever-increasing dependence on information technology, which dates within a year if not months, it is hard to argue the case for a contestable banking market on practical grounds alone. For example, secondary markets exist for used furniture but in banking it might be difficult, if not impossible, to sell computer hardware and systems, because of dating or compatibility problems. Indeed the lack of compatibility of IT systems is often cited as a problem for newly merged firms because it prevents them from getting costs down quickly.

9.4.5. Testing for Competition Using a Generalised Linear Pricing Model

It was noted that testing for competition using the SCP or relative efficiency hypothesis has numerous difficulties, giving rise to a remark by Berger (1995):

38 Nathan and Neave (1991) reply to this criticism.

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‘‘Despite. . . it does not appear that any of the efficient structure or market power hypotheses are of great importance in explaining bank profits.’’ (Berger, 1995, p. 429)

Some studies using more recent data and Berger’s techniques have found some evidence to support the relative efficiency hypothesis in some markets, but the results, at best, are patchy. Yet the SCP and relative efficiency hypotheses dominated the literature on microstructure bank behaviour over two decades. The dependent variable was either profitability or ‘‘price’’, for example, a loan or deposit rate. The use of the Panzer – Rosse statistic also has its limitations. As the most recent literature appears to have quietly conceded, it cannot be used to test for contestability, and there are doubts about any result which shows a country’s banking system to be perfectly competitive. An alternative approach suggested by Heffernan,39 yet to be used by other researchers for other countries, possibly because of difficulty obtaining the necessary micro-data.

To look at the competitive behaviour of banks, Heffernan asks: what are the factors influencing the decision to set deposit and loan rates, and from bank price setting behaviour, what if anything can be said about the model that best describes their behaviour? In common with the efficiency, scale/scope economies, SCP and relative efficiency model, the focus is on the retail banking market. It would be possible to conduct a similar exercise for the wholesale markets, data permitting. However, it is generally accepted that the wholesale markets are highly competitive because the customers are well informed, and in some cases, are not dependent on banks for external finance, and there are a large number of players offering a wide range of products. On the other hand, customers in the retail markets tend to be ill-informed and consumers show signs of serious inertia. The presence of scale and scope economies40 is indicative of imperfect competition. Even the Panzer – Rosse statistic may suggest the presence of imperfect competition in the banking sector.

The work by Heffernan attempts to go a step further by looking at pricing behaviour. It begins with a generalised pricing equation, which can be applied to the key retail banking

products: deposits, loans, mortgages and credit cards.

For mortgages and loan products, the equation is:

39See, for example, Heffernan (2002).

40The evidence is mixed, but more recent studies have suggested their presence.

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where

Rlit : loan or mortgage annual percentage rate charged by firm i at time t

and for credit cards:

j

where

fit : FEE for credit cards charged by firm i at time t.

Equations (9.20) through (9.22) were estimated by ordinary least squares,41 using monthly rates for savings, chequing, mortgage, loan and credit card rates, for the period 1993 – 99. The rates for the savings and chequing accounts are obtained by using the rate quoted by each bank or building society at representative ‘‘high’’ and ‘‘low’’ amounts.42 This yields four products: high and low savings and high and low chequing. The savings account includes all firms quoting a rate for a 90-day deposit. An interest penalty is incurred if the deposit is withdrawn within three months. The chequing product is a current account which pays interest on accounts in credit, and offers a range of free services, such as chequing and direct debit/credit facilities, ATM access and monthly statements, among others.

To test for the degree of competition in the banking market, a benchmark for a perfectly competitive rate is required, against which deposit and loan rates can be compared. Libor, the London Interbank Offered Rate, is the rate banks quote each other for overnight deposits and loans. Libor represents the opportunity cost of all of a bank’s assets; for a bank that aims to maximise expected profit, it is the basis for determining the marginal revenue for all assets, and the marginal cost of all liabilities. It is an international rate, to which all banks have access, and therefore, is representative of a perfectly competitive rate. For these reasons, Libor is treated as a proxy for the perfectly competitive deposit/loan/mortgage/credit card rates. This study employed a monthly average of the daily 3-month Libor rate available from Datastream and other sources. Since retail rates are unlikely to respond to changes in current Libor immediately, the rate was lagged by one, two and three months.43

41OLS is adequate if estimating a pooled data set of firms across a number of years. However, in later studies where more data meant it was possible to run regressions for each bank and pooled regressions, there were unacceptable levels of serial correlation when the OLS procedure was used in the individual firm estimations. The use of an autoregressive error regression model that computes maximum likelihood estimators (i.e. AR(1) or AR(2)) resolved the problem. The time series regressions yield an adjusted R2 of >0.95 for most of the FIs, and the Durbin Watson (DW) results show the null hypothesis of no serial correlation can be accepted. The pooled results display predictably lower adjusted R2 s.

42These representative high and low deposit levels were calculated using data from the British Bankers Association. See Heffernan (2002) for a complete explanation. This gave a high and low amount for each of the years, 1993 – 99.

The average amount for savings was £23 811 (high) and £2107 (low); for chequing it was £2107 (high) and £310 (low).

43 In Heffernan (1997), an error correction model was used to capture the dynamics of retail deposit and loan rates to changes in a base rate. The results (see, in particular, table 6, p. 223) provide econometric justification for choosing current Libor and Libor lagged by one, two and three months, respectively.

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The variable n allows a test for Cournot behaviour, which is present if the coefficient on FIRMS is significantly positive (negative) in the deposit (loan) equations. An indirect test of perfect contestability is also possible. In this study, if the coefficient on FIRMS in equations (9.20) to (9.22) is significant, then contestability is rejected because the number of incumbent firms should not influence deposit or loan rate setting.

The DUMMY variable for each firm permits a direct test of the theoretical model of monopolistic competition with bargains and rip-offs developed by Salop and Stiglitz (1977). Normally, a rise in market demand, or a fall in fixed costs, will attract more firms and, one would expect, generate greater competition. However, despite the large number of players in the market firms in this model are able to offer relatively good or bad buys to the consumer. In the Salop – Stiglitz model, consumers face unseen information costs. Some know the distribution of prices and others don’t. The former only buy bargains; the latter buy randomly. A firm can survive either by charging a low price (bargain) or a high one (rip-off). Rip-off firms stay in business as long as there are enough purchases by the ill-informed (or inert) consumers. Firms offering bargain products profit from a higher volume of sales, because well-informed customers buy their relatively cheaper product. Thus, the relative bargains and bad buys co-exist, and there is a twin-peak price distribution.

Some consumers of retail bank products are well informed; others are not, enabling the Salop – Stiglitz theory to be put to the test. The dummy variable captures the competitive behaviour of each individual firm, relative to a default bank. The Royal Bank of Scotland was chosen as the default, thereby acting as a benchmark against which the behaviour of all the other institutions can be studied. The bank was selected because it satisfied a number of criteria: it was important to include the ‘‘big four’’ (Barclays, Lloyds, Midland and National Westminster44 ) and new players in the rankings, and the default firm had to have a complete set of data for all the products over the period of testing, 1993 – 99. In fact, the choice of default bank (with whose interest rates other banks’ rates are compared) has NO significance for the ranking of financial institutions, nor (apart from a common constant) fo the interest rate deviations. Had another comparator bank been chosen, all the deviations from it change by the value of the coefficient on the default bank. However, the range of deviations does not change, nor do the relative rankings.

A negative coefficient on a bank offering one of the deposit products means this bank is offering a bad bargain or rip-off relative to the default bank; a positive coefficient indicates a relative bargain. For loan products, the opposite is true; a negative (positive) coefficient confirms the presence of a relative bargain or good buy (rip-off or bad buy).

In the Salop – Stiglitz model, the coefficient on the number of firms offering the product may also be negative for deposit products and positive for loans, the opposite sign expected for the Cournot model. For example, a fall in fixed costs could be one of several reasons why new firms enter the market. Hence, firm entry could rise, and with it, the number of relative rip-offs. On the other hand, a Salop – Stiglitz framework is compatible with the Cournot prediction that as firm entry increases, deposit rates will rise and loan rates will

44 During the period of study (1993–99), Lloyds Bank took over the Trustees Savings Bank in December 1995 and began calling itself Lloyds TSB in 1999. The Hong Kong and Shanghai Bank Corporation took over the Midland Bank in 1992; in late 1999 the Midland branch network was renamed HSBC.

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existing borrowers, who are locked in and face high switching costs. Compared with the 1985 – 89 study, there appears to be little change in this market.

The very high significant constant terms found for personal loans and credit cards are indicative of large margins for the banks. For all products, the prominence of the lagged Libors shows banks respond to a change in Libor over several months. The coefficient on FEE was strongly significant and positive in the credit card regression.45 As the annual fee rises, so does the credit card rate charged. Financial firms charging annual fees are unquestionably engaging in price discrimination because other credit cards are available with similar non-price features and no annual fee. Either fees and/or the rate charged can be the source of a rip-off.

Current Libor is significant in only one case, existing borrowers using the top financial institutions, indicating there is a partial, immediate rate response to changes in the interbank rate. All the regressions have at least one lagged Libor which is significant.

Table 9.5 shows the results of the bargain rip-off test (column 2) and the sign of the coefficient on n, the number of firms (column 3) offering the product. Taken together, this

Table 9.5 Models of Imperfect Competition by Product (1993–99)

SS: Salop Sitglitz.

45 The coefficient on FEE was 0.166 with a t-ratio of 10.1.

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information makes it possible to classify a product according to the model of competition which best describes it.

Begin with column 2. These margins come from the coefficients on the dummy variables which are used to capture the extent of the rate setting differences across banks for a given product. Consider personal loans. The margin of 8.17% indicates there is a difference of 8.17% between the best bargain bank (margin of −3.8%) and the worst rip-off, where the bank earns a margin of 4.9%. The coefficient on firm variable is insignificant. With such a large margin and no evidence of Cournot-like behaviour, this suggests the Salop – Stiglitz model of monopolistic competition, where banks offer relative bargains and rip-offs both survive in the marketplace. The price setting behaviour by banks for all but three of the products is best described by a bargain/rip-off model of monopolistic competition. Mortgage products are the key exception. Recall the earlier evidence suggesting that existing borrowers suffered from price discrimination because they were locked into a mortgage. The lack of support for the Cournot model, and the small margin between the best bargain and worst rip-off, tends to confirm this. For new mortgagees, the margin is also small, but the coefficient on number of firms is significant but the opposite of what would be expected by Cournot – rates rise with more firms. Based on this evidence, it appears the market is competitive but not contestable, because the firm entry coefficient is significant, and in a contestable market, it should not be.

A similar approach46 was used to examine whether UK building societies, which are mutuals, changed their pricing behaviour once they converted to shareholder owned status. After the 1986 Building Societies Act (see Chapter 5), eight opted to convert between 1995 and 2000.47 The period covered was 1995 to 2001 for a sample of converted societies and mutuals. The presence of imperfect competition in UK retail banking has already been confirmed, which gave the financial institutions market power. Under these conditions:

žThe new stock banks became more price sensitive post-conversion – they were far more likely to respond rapidly to a change in Libor than building societies.

žAfter they converted to bank status, deposit rates were found to be permanently lower, and mortgage rates permanently higher.

žUsing the Salop – Stiglitz test, the new converts were found to offer predominantly rip-off products.

9.4.6. Competition in the Canadian Personal Finance Sector

With 3% of the world’s bank deposits, Canada provides an example of a nationally integrated banking system with relatively high concentration, much higher than the USA. Historically, the Canadian financial sector consisted of five financial groups. Federally chartered banks focused on commercial lending, and since the late 1950s, personal lending and mortgages. Trust and mortgage loan companies originally offered trust and estate administration services and later, mortgages and long-term deposits. In the 1980s, trust companies expanded into the personal financial sector by offering demand deposit, shortterm deposit and personal lending products. Trust companies are normally in possession

46Heffernan (2005).

47Abbey National had converted in 1989.

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žIn comparison to the studies of Canadian banking by Nathan and Neave (1989), Nathan (1991) and Shaffer (1990), which cover similar years, this investigation finds no evidence to support a contestable markets model for the Canadian banking market, or one which exhibits features of traditional monopolistic competition. Rather, the findings here are consistent with Cournot-type behaviour of financial firms, where the gap between price and marginal cost is negatively related to the number of firms in the market. In a contestable market, firm entry would not affect prices. Significant coefficients found on the financial group dummy variables mean different financial groups exhibit price-making behaviour for some personal finance products, offering relative bargains for some products, relative rip-offs for others. The presence of systematic pricing differences between the ‘‘fifth column’’ and minor firms operating in local markets is also inconsistent with the predictions from models of contestability and monopolistic competition.

žThere were notable, significant differences in the relative pricing behaviour of the different groups. Trust companies were price-makers, setting above-average interest rates on mortgages. The chartered banks were shown to exert a strongly negative influence on term deposit rates in 1987 and 1988, but trust companies had a significantly positive influence on deposit rates in all four years. Domestic banks also exert a negative influence on RSP rates. Foreign banks offered relative rip-off RSPs and mortgages but, in most cases, bargain term deposits.

žThe dummy variable coefficients permitted a ranking of the different financial groups according to the degree of bargain/rip-off product on offer. In the case of mortgages, no one group offered a particularly good or bad rate. For term deposits, trust companies offered a relatively good deal, followed by savings and loans, foreign banks and domestic banks. For RSPs, trusts and foreign banks offered the best deal, followed by life insurance firms and banks. Life insurance firms offered a relatively bad deal on RIFs in 1987 and 1990, but a better rate in 1989.

There are some qualifications to the procedures used in the generalised pricing model. First, it is often argued that financial institutions produce financial products jointly, and hence looking at the rates associated with a single deposit or loan product may be misleading. While it is correct to recognise the joint production of deposit and loans, one would have to have detailed data on the relevant cost functions to model it empirically, and they are not available. Furthermore, there is nothing to stop a customer from using a different financial firm for each of the deposit and loan products. The presence of transactions or switching costs may mean customers maximise their utilities by purchasing personal finance products at one firm but if true, such behaviour creates the opportunity for the financial firm to discriminate in prices. Furthermore, practitioners in the field report that when deciding upon, say, a deposit rate for a particular retail product, their principle concerns, among others, are the number of close substitutes, the ease with which consumers can switch, the actual switching rates, range of prices of similar products on the market, and in the case of loans, the credit risk profile. While in aggregate the number of loans are linked to deposits/funding, these other factors determine how loans and deposits are actually priced.

A second caveat concerns risk characteristics. If one bank is considered by depositors to have a higher probability of failure than other financial firms, then the funding costs for the