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Market Size, Service Quality, and Competition in Banking

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  • The opinions expressed do not necessarily reflect those of the Federal Reserve System or the Federal Reserve Bank of New York. This paper is based on earlier work titled “Market Structure and Quality: An Application to the Banking Industry,” from the author's Ph.D. dissertation, and it circulated previously under the title “Competition in Banking: Exogenous or Endogenous Sunk Costs?” The author is grateful to the editor, anonymous referees, as well as Susan Athey, Evren Örs, and Nancy Rose for their insightful comments. She would also like to thank Allen Berger, Steve Berry, Paul Ellickson, Timothy Hannan, Michael Orlando, Julio Rotemberg, Michael Salinger, as well as participants at the International Industrial Organization Conference, the Federal Reserve Bank of Chicago Bank Competition and Structure Conference, and a Federal Reserve Bank of New York seminar for their suggestions. Any remaining errors are the author's.

Abstract

Local banking markets depict enormous variation in population size. Yet this paper finds that the nature of bank competition across markets is strikingly similar. First, markets remain similarly concentrated regardless of size. Second, the number of dominant banks is roughly constant across markets of different size; it is the number of fringe banks that increases with market size. Third, service quality increases in larger markets and is higher for dominant banks. The findings suggest that banks use fixed-cost quality investments to capture the additional demand when market size grows, thereby raising barriers to entry.

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