An examination of entry and competitive performance in rural banking markets.

• Author: Feinberg, Robert M.
• Position: Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994

1. Introduction

   The 1994 Riegle-Neal Act ushered forth a new era in banking deregulation. As noted by former Federal Reserve Chairman Alan Greenspan in a 2005 speech, deregulation resulted in a 50% decline in the number of banks due to industry consolidation. However, this decline did not necessarily indicate that the level of competition declined; Greenspan (2005) further notes that despite the decline in the number of banks, measures of local market banking competition remained relatively stable between 1990 and 2005.

   This article explores the nature of competition in rural banking markets over the decade following the 1994 Riegle-Neal Act. Using a recently developed empirical model that utilizes the number of banks as well as the value of deposits in a cross-section of rural markets, we decompose the impact of the entry of new banks into resulting changes in per capita demand and the costs/profits of local banks in 1994 and 2004. The results support Greenspan's claim that banking markets have become more competitive in the 10 years following passage of the Riegle-Neal Act.

2. Literature Review

   There is a long empirical literature on entry--both determinants and effects--usually based on manufacturing industry data. Early banking entry articles include Hanweck (1971) and Rose (1977). More recently, Amel and Liang (1997) present interesting results on bank entry fairly closely related to this article's focus. They jointly explain bank profits and entry over the 1977-1988 period for about 2000 rural counties and about 300 urban markets (metropolitan statistical areas) and find that supranormal profits promote entry, as do population and population growth, and that entry has the anticipated procompetitive effect of reducing profits, though only in rural markets.

   Most of the previous studies look at bank entry in the pre-Riegle-Neal Act (banking deregulation) period. However, since then Berger et al. (2004), Seelig and Critchfield (2003), and Keeton (2000) have all found--though with somewhat differing definitions of merger activity and samples--that merger activity generally tends to promote de novo entry. These findings are consistent with merger activity and/or the presence of "big banks" in a market as signaling to potential entrants the opportunities for supranormal profits to be earned. (1)

   Others have recently studied market dynamics in local banking markets. Both Dick (2007) and Cohen and Mazzeo (2007b) find that the incumbent banks in markets tend to expand via new branches to aid in deterring new entry when demand grows. Similarly, Berger and Dick (2007) find that early entrants in banking markets seem to be able to entrench their positions and have persistently higher market shares.

   The work by Bresnahan and Reiss (1991) stimulated a wave of empirical research on entry. They explain entry in terms of the cross-sectional response to market size; specifically, they hypothesize that if the per firm market size needed to support a given number of firms is getting higher with the number of firms in the market, then competition must be getting stronger. In other words, the fact that larger sales are required to offset the fixed costs of entry implies more competitive pricing. A discrete choice model relates these "entry thresholds" and how they change with subsequent entry to predictions about price behavior associated with increasing numbers of firms. (2) Bresnahan and Reiss (1991) take the view that isolated rural markets are best suited to testing hypotheses regarding entry, generally because of the difficulty in accurately drawing market boundaries in metropolitan areas or even in rural counties adjacent to metropolitan statistical areas (MSAs).

   Cetorelli (2002) uses the Bresnahan and Reiss (1991) (BR) methodology to examine local banking markets and explain (equilibrium) market structure by population and other county economic characteristics; the article analyzes numbers of banks in a large sample of nonmetropolitan counties for 1999. While we would argue that contiguous rural counties may not represent the most appropriate geographic market definition for local banking, his estimated ordered-probit coefficients suggest significant market power at least until there are five banks in a county. (3)

   Cohen and Mazzeo (2007a) apply a variant of the BR approach to rural banking markets. They look at data for a large number of rural banking markets in 2000 and 2003 to examine the nature of competition within and across three types of institutions: multimarket banks, singlemarket banks, and thrifts. As in this article, they choose to define markets in terms of Bureau of Labor Statistics "labor market areas" (LMAs), which combine contiguous counties depending on commuting patterns to better proxy geographical markets for financial services. Cohen and Mazzeo (2007a) find significant product differentiation (that competition within types is more aggressive than it is across types) and that variable profits are significantly reduced by the second firm in a given type, this reduction becoming smaller for subsequent entry.

   We also use a variant of the BR approach to examine endogenous market structure in local banking markets (where price and cost information are difficult to obtain for the bundle of services provided). However, we consider only rural LMAs at least one market removed from an MSA and not adjacent to any other sample LMA. Although this restriction--designed to minimize errors in market definition and correlations across markets--makes our sample of markets somewhat smaller than that used in other recent studies of banking entry, it does encompass 278 rural markets (across 39 states) in the United States.

   We also consider the issue of banking competition in small rural markets in a somewhat different manner than do Cetorelli (2002) and Cohen and Mazzeo (2007a), applying the methodology of Abraham, Gaynor, and Vogt (2007) (AGV). (4) AGV extend the BR approach by incorporating information on quantity to analyze the level of competition in the U.S. hospital industry. They claim (p. 266) that using information about quantity "allows us to separate changes in fixed cost associated with entry from changes in the toughness of competition." In their sample of hospital markets, they find that relatively few firms are required to bring competitive behavior (by reducing variable profits and increasing market quantity), with limited effects beyond three firms in a market.

   Unlike Cohen and Mazzeo (2007a) and Mazzeo (2002), the AGV model assumes that firms produce a homogenous product. (5) But, unlike these aforementioned articles, this model does not have to assume that fixed costs of entry remain constant as the number of firms in the market grows. For this reason, we believe that the AGV model is ideally suited to study competitive conditions in the banking market. The requirement of homogeneity in the context of local consumer banking seems less onerous than the assumption that market crowding with increased numbers of banks has no impact on entry costs (as might be due to the need for greater marketing expenses). The model allows us to use observed data on market structure and quantity (but not prices) to study the level of competition in a market.

3. Model

   As noted previously, we utilize an econometric model derived in Abraham, Gaynor, and Vogt (2007). In the following paragraphs, we provide a brief outline of the model. The market demand for banking services is defined by

   Q = d(P, X)S(Y), (1)

   where per capita demand, d(P, X), is a function of price and exogenous demand shifters (X), such as per capita income. The total market size, S(Y), is an increasing function of population. Each bank's costs are characterized by constant average variable costs, A VC(W), and a fixed cost, F(W), both of which depend upon cost shifters, W.

   As in Bresnahan and Reiss (1991), we assume that each market reaches a symmetric equilibrium in price. The equilibrium market price in a market with N firms, [P.sub.N](X, W, [[theta].sub.N]), depends upon demand and cost conditions and the degree of competition, as represented by [[theta].sub.N]. The equilibrium market price determines the equilibrium values of per capita quantity, fixed costs, and variable profit margin (price minus average variable costs), or d([P.sub.N], X), [F.sub.N](W), and [V.sub.N]([P.sub.N], W), respectively.

   We observe the number of banks (N) and the quantity of deposits (Q) for each market. A bank will enter the local market only if it will earn non-negative profits. The Nth firm in the market earns profits equal to

   [[PI].sub.N] = [V.sub.N]S/N[d.sub.N] - [F.sub.N]. (2)

   The minimum market size per firm needed to support N firms, [S.sub.N], can be found by solving Equation 2 for the zero-profit condition. As in Bresnahan and Reiss (1991), we calculate the ratio of the minimum per firm market size needed to support a market with N + 1 versus N firms, or the entry threshold ratio, as

   [[S.sub.N+1]/[S.sub.N]] = [[F.sub.N+1]/[F.sub.N][[[V.sub.N][d.sub.N]/[V.sub.N+1][d.sub.N+1]]. (3)

   As discussed above, Bresnahan and Reiss (1991) hypothesize that if the per firm market size needed to support a given number of firms is getting higher with the number of firms in the market, then competition must be getting stronger. Stronger competition reduces prices and, thus, profit margins; as a result, a larger market size is needed to cover the fixed costs of entry. A threshold ratio greater than one implies that competition is getting stronger, while a threshold ratio equal to one implies that the degree of competition remains unchanged with the entry of an additional firm. Threshold ratios...