Testing for imperfect competition on EU deposit and loan markets. with Bresnahan s market power model

Transcription

1 Testng for mperfect competton on EU depost and loan markets wth Bresnahan s market power model J.A. Bkker 1 February 2003 Research Seres Supervson no. 52 Secton Bankng and Supervsory Strateges, Drectorate Supervson, De Nederlandsche Bank P.O. Box AB Amsterdam The Netherlands 1 Secton Bankng and Supervsory Strateges, Drectorate Supervson, De Nederlandsche Bank. Emal address: j.a.bkker@dnb.nl; Fax: ; Tel.: The vews expressed n ths paper are those of the author and not necessarly those of the Nederlandsche Bank. The author s grateful to Katharna Haaf for contrbutons to an earler verson of the paper, Peter Vlaar for helpful comments and Mram Holman-Rjken for excellent research assstance.

2 Testng for mperfect competton on EU depost and loan markets wth Bresnahan s market power model 2 J.A. Bkker Abstract Bresnahan and Lau developed a model of proft maxmsng olgopoly banks n order to determne the degree of market power of the average bank. The equlbrum prce equaton ncludes a mark up, whch s not used at all under perfect competton, partly used under olgopoly or monopolstc competton and fully used under monopoly. The data requrements of the model allow testng of possble use of market power for submarkets. Ths artcle nvestgates the degree of competton on both the depost and loan markets n nne EU countres, both apart and jontly. The hypothess of perfect competton can be rejected for the depost market of the entre EU, for the depost markets of Germany and Span and for the lendng markets of Germany, Portugal, Span, Sweden and the UK. Nevertheless, these markets are charactersed as hghly compettve, because the use or abuse of market power s very lmted. JEL code: E43, E51, F36, G21, L1; Keywords: banks, market power, (perfect) competton, olgopoly, Cournot equlbrum, loan markets, depost markets, cross-country comparsons;

3 3 Testng for mperfect competton on EU depost and loan markets wth Bresnahan s market power model J.A. Bkker I. INTRODUCTION In recent years, numerous developments have affected the markets where banks operate: deregulaton, lberalsaton, globalsaton and varous technologcal nnovatons. Each of these developments has nfluenced the compettve condtons of banks. Addng to ths, monetary and fnancal ntegraton n Europe, ncludng the ntroducton of the euro, has contrbuted to a further ncrease of foregn competton n the regon. As banks market power affects ther proftablty, compettve conduct also has an mpact on the soundness and stablty of the fnancal sector. Healthy competton and a sound market structure are also mportant for socal welfare, mplyng as they do low prces, low nterest rates and adequate lendng to consumers and frms, n partcular small and medum-szed enterprses. Market mperfectons would cause allocatve neffcency and so detract from the prosperty whch socety derves from bankng servces. Of course, t should be kept n mnd that compettve condtons dffer across product and geographcal markets and are also subject to contnuous changes over tme. Fnally, the compettve structure of fnancal markets has major mplcatons for the effectveness of certan nstruments of monetary power, such as the dscount rate and requred cash reserves. The effects of monetary polcy on fnancal prces and quanttes depend crucally on the extent to whch ndvdual banks are n a poston to explot credt demand and depost supply functons (Swank, 1994). Remarkably enough, gven the vtal mportance of competton for socal welfare and polcy makng, the economc lterature provdes only lmted nformaton about compettve conduct n the European bankng markets. Apart from measurement problems competton cannot be observed drectly a lack of suffcent data also mpedes a clear vew on bank market structure, especally outsde the US. Therefore, varous measurement approaches are needed to squeeze the lmted data sources dry. The lterature on the measurement of competton among banks may be dvded nto two major streams: structural and non-structural approaches. The structural approach to the measurement of competton embraces the Structure-Conduct-Performance paradgm (SCP) and the effcency hypothess, as well as a number of formal approaches wth roots n Industral Organsaton theory (Bkker and Haaf, 2002 b ). The two former models nvestgate, respectvely, whether a hghly concentrated market causes collusve behavour among the larger banks resultng n superor

4 4 market performance or, conversely, whether t s the effcency of larger banks that enhances ther performance. In reacton to the theoretcal and emprcal defcences of the structural models (Bkker and Haaf, 2002 b ), non-structural models for the measurement of competton were developed, namely the Iwata model (Iwata, 1974), the Bresnahan model 2 and the Panzar-Rosse model (Panzar and Rosse, 1987). These New Emprcal Industral Organsaton approaches test compettve conduct and the use of market power, and stress the analyss of banks compettve conduct n the absence of structural measures. The Iwata model has hardly been used emprcally, an excepton beng Shaffer and DSalvo (1994), who apply t to a two-bank market. The Panzar and Rosse (PR) model has proven to be a useful tool for observng competton. Ths model s based on the comparatve statc propertes of the reduced-form bank revenue equaton. The P-R model uses data for ndvdual banks, whch tend to be avalable n ample quanttes, allowng farly precse estmatons of competton (Bkker and Haaf, 2002 a ). A dsadvantage of the P-R approach s ts assumpton that banks provde one bankng product only. Hence, t does not allow us to dstngush between dfferent product or geographcal markets, whch by the way would also be hampered by a lack of requred data, e.g. bank-level nterest rates and producton fgures. Ths s precsely where Bresnahan s model can play a supplementary role, as t allows the nvestgaton of submarkets, due both to ts nature and to ts data requrements. On the other hand, Bresnahan s model uses macroeconomc data, whch lmts ts possbltes, because these data are made avalable on an annual bass only. The present paper apples Bresnahan s model to two submarkets, deposts and loans, n nne countres of the European Unon (EU). For each submarket, we apply the model to all countres together as well as to each of the nne ndvdual countres. Ths survey s unque n ths body of lterature n that t compares market power for so many countres. The depost market reflects banks compettve condtons wth respect to fundng and hence mrrors ther actvtes on the labltes sde of the balance sheet. The product or servce consdered here s the supply of depost facltes. Ths retal market s nterestng as t s by nature localsed, so that the number of competng banks tends to be lmted, except for the more recently mushroomed Internet banks. The ntroducton of Internet bankng may have ncreased competton n ths market. On the other hand, t should be noted that the Internet s an alternatve for part of the customers only. The loan market refers to the man (tradtonal) actvty of banks, lendng, whch s representatve of the assets sde of the balance sheet. The lendng market has manly a naton-wde or nternatonal dmenson, assumng that only smaller amounts are nvolved n lendng to (local) small and medum-szed enterprses. These markets may be assumed to be farly compettve, as banks n ths busness usually face many foregn compettors. Gven the data requrements of Bresnahan s 2 See Bresnahan (1982) and Lau (1982). Ths technque s elaborated further n Bresnahan (1989).

5 5 model, the choce for deposts and loans s also determned by the avalablty of the pvotal prces on these markets: the depost and lendng rates. Ths paper has been organsed as follows. Secton II sets out the theoretcal structure of the Bresnahan model and ts emprcal applcaton to the depost and loan markets. Secton III descrbes the data and estmaton methods used and presents the estmaton results for both markets n the whole EU regon, as well as n each of the nne EU countres separately. Fnally, a comparson s made to other studes employng Bresnahan s model or related approaches. Secton IV contans a summary and conclusons. II THE BRESNAHAN MODEL In order to seek to determne the degree of market power of the average bank n the short run, Bresnahan (1982) and Lau (1982) developed an Industral Organsatons type of model of proft maxmsng olgopoly banks. The Bresnahan model we wll use s based on the ntermedaton paradgm of a bank, as n Shaffer (1989, 1993), who furthermore assumes that banks produce only one product and use several nput factors. 3 As proposed by Shaffer, our cost functons are based on factor nput prces. Takng for granted that factor nputs are not the same for loans and deposts, our Bresnahan model separates the costs of bankng actvtes,.e. t gnores the nterdependence of cost functons for the two products. We estmate the demand and supply relatons separately for the depost and loan markets, assumng that banks try to maxmse profts at the product level rather than takng advantage of possble cross-subsdsaton between products. Ths secton begns by descrbng the general theoretcal structure of the Bresnahan model, as used by Shaffer, and then dfferentates to emprcal models for the depost and loan markets, respectvely. 1. Theoretcal structure of the Bresnahan model Assumng n banks n the ndustry supplyng a homogeneous product, the proft functon of the average bank takes the form: Π = px c x, EX F (1) ( S ) where? s proft, x s the volume of output, p s the output prce, c are the varable costs, EX S are exogenous varables affectng the margnal costs, but not the ndustry demand functon, and F 3 Alternatvely, Suomnen (1994) and Swank (1995) employ two-product models (deposts and loans) and assume the nterdependence of product demand and margnal cost functons, but nether of them employs cost functons ncludng factor nput prces.

6 6 are the fxed costs of bank. In the loan market, the output prce p can be defned as the dfference between the lendng rate and the rate of rsk free nvestment (such as government bonds). An alternatve would be to assume that p s equal to the lendng rate and to nclude the fundng rate as a cost factor. In the depost market, the output prce p s the dfference between the rsk free rate and the depost rate, hence the dscount banks receve when they fund wth deposts nstead of other types of fundng. Banks face a downward slopng market demand functon, the nverse of whch s defned as: (2) p = f ( X EX ) = f ( x + x +... x, EX ), D n D where EX D s a vector of exogenous varables affectng ndustry demand but not margnal costs. The frst order condton for proft maxmsng of bank yelds: dπ dx (3) = p + f ( X, EX ) x c ( x, EX ) = 0 D dx dx S Takng averages over all banks produces: so that: dx 1 p + f D S n dx n ( X, EX ) X Σ c ( x, EX )/ = 0 (4) p = λf ( X EX ) X + Σ c ( x, EX ) n λ = = 1 + j where ( dx dx ) n ( d x dx ) n j, D S /. Thus,? s a functon of the conjectural varaton of the average frm n the market. The conjectural varaton of frms s defned as the change n output of all remanng frms antcpated by frm n response to an ntal change n ts own output. For the average bank n a perfectly compettve market, the restrcton λ = 0 holds, as, n a compettve equlbrum, prce equals margnal cost. Snce prces are assumed to be exogenous to the frm n a perfectly compettve market, an ncrease n output by one frm must lead to an analogous decrease n output by the remanng frms, n lne wth equaton (4). The Cournot equlbrum descrbes noncooperatve optmsaton where agents who mutually nfluence each other act wthout explct cooperaton. Under that type of equlbrum, the conjectural varaton ( d j x j dx ) for frm would equal zero. The Cournot model assumes that a frm does not expect retalaton from other frms n response to changes n ts own output, so that

7 7 λ =1 n. 4 Under perfect colluson, an ncrease n output by one of the colluders leads to a proportonal ncrease n output by all other colluders, yeldng ( + ) = ( 1 + ( X x ) x ) n = X x n = 1, λ = 1 d x dx n. Hence, under normal condtons, the? parameter takes values between zero and unty. The? parameter n Bresnahan s model plays a role smlar to that of the H parameter n the P-R approach, where H<0 ponts to monopoly, 0<H<1 ndcates monopolstc competton and H=1 reflects perfect competton. j j As mentoned above, we apply the Bresnahan model to the two most promnent submarkets of the bankng ndustry: the loan and depost markets. To assess the degree of market power, we smultaneously estmate market quantty and prce curves, obtanng the value of? whch ndcates the degree of competton. 2. Emprcal equatons for the depost and loan markets For the emprcal model of the depost market, the theoretcal demand functon (2) s redefned as a lnear aggregate demand functon for depost facltes offered to non-banks and reads: (5) DEP = α 0 + α1rdep + α 2EX D + α 3EX Drdep + ε where DEP s the real value of total deposts, r dep s the market depost rate, 5 EX D are exogenous varables affectng ndustry demand for deposts but not margnal costs, such as dsposable ncome, unemployment, the number of bank branches 6 and nterest rates for alternatve nvestment (.e. the money market rate and the government bond rate) and ε s the error term. Equaton (5) should also nclude one or more cross-terms between the depost rate and at least one of the exogenous varables determnng demand for depost facltes (on the dentfablty of the? parameter, see below). The tme subscrpts n equaton (5) and later equatons are deleted for convenence. The margnal cost functon for bank c (, ) x EX S n equaton (3) s defned as: 4 The assumptons underlyng the Cournot olgopoly theory accordng to Hause (1977) are: homogeneous products, n frms wth strctly ncreasng margnal cost functons (whch need not be dentcal), ndependent (noncooperatve) behavour of frms to maxmse ther own profts, no entry, and ndustry demand s strctly decreasng. 5 As suggested above, an alternatve would be to defne the prce as the dfference between rsk free (or money market) rate and depost rate. In our emprcal applcaton, ths would be equvalent to ths model, as alternatve rates (such as the money market rate) are also ncluded as dependent varable. 6 Data on branches were unavalable for our emprcal analyss.

8 8 (6) MC = β 0 + β1dep + β 2EX + ν S where EX S are exogenous varables nfluencng the supply of deposts (costs of nput factors for the producton of deposts, for nstance, wages) and ν s the error term. Re-arrangng the aggregate demand functon (5) yelds the prce functon as: 1 + α EX (7) [ DEP α α EX ε ] rdep = 0 2 D α1 3 D whch, multpled by the deposts of bank yelds ts total revenue as: TR 1 = DEP α α 2EX α + α EX (8) [ 0 D ] 1 3 D ε DEP and, derved wth respect to the deposts at bank, ts margnal revenues: (9) MR + α 1 dtr = ddep 1 + α EX 3 D = α α EX 3 D ddep DEP = r ddep [ DEP α α EX ε ] dep + α 1 0 λn + α EX 3 2 D D DEP where λ s defned as below equaton (4). Market equlbrum requres the equalty of margnal revenues and margnal costs, so that for each bank: λn (10) rdep + DEP = β 0 + β1dep + β 2EX S + ν α + α EX 1 3 D The equlbrum prce equaton for depost facltes by the banks,.e. the depost rate, follows from takng averages: (11) λ DEP * * r = + β + β + β ν α + α + dep 0 1 DEP 2 EX S EX 1 3 D where ß 1 * = ß 1 /n, ß 2 * = ß 2 /n and EX EX S = S S. In order to determne λ, the degree of competton of the average bank n the depost markets of the countres consdered, the quantty 7 7 The equlbrum verson of the demand equaton for Deposts, that s equaton (5) after substtuton of the equlbrum prce r dep from equaton (11).

9 9 and prce equatons, (5) and (11), respectvely, must be estmated smultaneously, as the parameters a 1 and a 3 occur n both equatons. Lau (1982) and Bresnahan (1982) show that, whereas both the demand (a) and supply (ß) parameters are dentfed, the λ parameter s dentfable only f the demand functon ncludes the endogenous nterest rate (or prce ) and a cross-term wth one of the explanatory (other) varables and ths nterest rate. 8 In other words, λ s dentfed only, f the assumptons a 1? 0 and a 3? 0 both hold. Note that a 1 s expected to be postve, so the frst term of the rght-hand sde of equaton (11) s λ tmes a markdown. Ths mples a lower depost rate n the case of no or lmted competton, as seems plausble. Note that, n prncple, equatons (5) and (11) can generate an estmate of competton, even where the correspondng market s facng competton from fnancal nsttutons not ncluded n the natonal samples, such as non-banks, tradtonal foregn banks and Internet banks. After all, even where competton from other banks s lmted, banks are unable to wden the margn between prce (or nterest rate) and costs when competton from non-banks s heavy or even s only a serous potental threat. In a smlar manner, the aggregate demand (or quantty) functon for loans by households and banks can be defned as: (12) LOANS = α 0 + α1rlend + α 2 EX D + α 3EX Drlend + ε where real LOANS are explaned by r lend, the lendng rate, by EX D, exogenous varables nfluencng the demand for loans, such as ncome, unemployment, the number of bank branches, the share of labour n total value added and the utlsaton rate of captal, and by ε, the error term. Agan, the equaton should contan at least one cross-term consstng of the lendng rate and one of the other varables determnng demand for loans facltes n order for the? parameter to be dentfed. On the analogy of the prce equaton for deposts presented above, the prce relatonshp for loans may be derved as: (13) λ LOANS rlend = + β 0 + β1loans + β 2EX S ν α + α EX D The smultaneous estmaton of equatons (12) and (13) generate the value of λ, provded ths parameter s dentfed. Note that a 1 s expected to be negatve, thus the frst term of the rghthand sde of equaton (13) s λ tmes a markup. Ths means a hgher lendng rate n the case of no or lmted competton, as seems plausble. 8 Ths s obvous from equaton (11): f a 3 = 0,? and ß 1 are ndstngushable from each other.

10 10 III ESTIMATION RESULTS The emprcal Bresnahan model, developed above, has been appled to the depost and loan markets of nne EU countres: Belgum, France, Germany, Italy, the Netherlands, Portugal, Span, Sweden and the UK, both separately and jontly. Other EU countres are not ncluded due to unavalablty of data. 9 For practcal reasons, we assume here that natonal markets correspond wth the natonal borders. We do realse that ths need not always be the case, as foregn banks and Internet banks may affect domestc compettve condtons. The models are based on tme seres of quarterly data from a varety of databases and nsttutons: the Internatonal Fnancal Statstcs (IFS), the Bank of Internatonal Settlements (BIS), the Organsaton of Economc Cooperaton and Development (OECD), Data Stream (DS), the Dutch Central Plannng Bureau (CPB), the Statstcs Netherlands (CBS) and several central banks. For a number of countres and varables, the avalablty of the requred data and the length of the seres are lmted. In many cases, there s a trade-off between qualty (seres wthout breaks) and quantty (longer seres). Specal attenton s pad to the German data wth respect to the German unfcaton. The tme seres used for our estmatons cover both the pre- and the post-unfcaton perod. Data for the Western states have been avalable untl 1990; as from 1991, both data for the Western states and aggregate data for the entre country are avalable. We used the data coverng the entre country after 1990 and adjusted the data for the perod precedng unfcaton. For real deposts, gross domestc product (gdp) and unemployment we dd not have overlappng data at our dsposal, hence we exploted dummes to take account of the (mprecse or unknown) adjustments. The data constrants, furthermore, hamper complete consstency n the defnton of the underlyng market across countres: depost and loan volumes are avalable for the bankng market n all countres except Belgum, where a broader defnton of the market,.e. one accountng for all credt nsttutons, s appled. The varables deposts, gdp, loans and wage rate are expressed n real terms n order to avod nterference from nflaton. For the all-countres sample, all volumes are expressed n Deutsche Marks whereas, n the ndvdual country estmatons, these varables are n the countres own currences. 10 The quantty and prce equatons form a smultaneous system, as each equaton ncludes the endogenous varable of the other equaton as explanatory varable. Therefore, the equatons have 9 For the other EU countres, we could not fnd data for all essental model varables. In partcular, approprate lendng rates are unavalable for a number of countres. 10 Volumes are expressed n bllons of Deutsche Marks. Inflaton and nterest rates are n percentages.

11 11 been estmated by the 2SLS method. 11 Account of the cross-equaton restrctons has been taken by estmatng the prce equaton condtonal on the estmated values of a 1 and a 3 n the quantty equaton. Because of the exstence of these cross-equaton restrctons, a system estmater such as 3SLM or FIML would be a more effcent - but also a more complcated - alternatve (Toolsema, 2002). All equatons for all countres and the EU regon contan all explanatory varables occurrng n the theoretcal model. For the quantty equatons, real deposts and real loans, we consder two cross-terms throughout, consstng of the prce (depost or lendng rate) and one of the other explanatory varables. 12 We need at least one cross-term, whereas ncluson of all cross-terms would be excessve and could cause multcollnearty. Hence, the choce of two cross-terms takes an ntermedate poston. In some equatons, there s the choce between money market and government rates 13 and also an opton to nclude other explanatory varables. In every case, the choce s based prmarly on natonal economc and nsttutonal crcumstances, e.g. characterstcs of the money and captal markets. Where a choce s arbtrary, we seek to fnd sgnfcant values for a 1 and a 3, whch s a condto sne qua non for our analyss, or to reduce autocorrelaton. Seasonal dummes are ncluded only, when one or more of the equaton varables have a seasonal pattern and are mantaned, when the dummes appear to be jontly sgnfcant. Intal estmaton has revealed that the error terms of some equatons exhbt seral correlaton, as ndcated by the Durbn-Watson (DW) or Durbn s h test, and Breusch-Godfrey s Lagrange Multpler (LM) test. Autocorrelaton may leads to overestmatng of the coeffcents t-values and hence to wrong nferences (Kennedy, 1998). Ths feature has been dealt wth ether through ncluson n the model of the lagged dependent varable as an explanatory varable, a so-called Koyck lag (Thel, 1971), or through ncluson of an autoregressve term n the error. A Koyck lag model assumes that the actual dependent varable adjusts gradually over tme to ts assumed model value (Nerlove, 1958, dscusses varous possble underlyng adjustment processes). 14 Gong by the DW or Durbn s h test, and the Breusch-Godfrey LM test, the autocorrelaton problem has been solved n a number of cases. In all cases, we calculate the Newey and West correcton for heteroscedastcty and autocorrelaton-consstent covarances, whch correct the t- values of the coeffcents for any possble remanng heteroscedastcty and autocorrelaton. Ths prevents us from makng wrong nferences from these t-values, e.g. regardng sgnfcance (Greene, 2000). 11 We use EVews 4.0, whch employs the Marquardt algorthm for non-lnear estmaton. Everywhere, all potental exogenous explanatory varables have been ncluded as nstrumental varables. 12 An excepton s the EU-wde real depost equaton. 13 Incluson of both rates would cause multcollnearty. 14 Besdes, ths model structure, lke autocorrelaton, may ndcate that at least one explanatory varable wth lastng effects has been omtted.

12 12 1. The market for depost facltes Quantty equaton (5) determnes the volume of deposts n terms of ts prce (the depost rate) and exogenous varables from the demand functon, such as the money market rate or the government debt rate, the volume of gdp, unemployment and nflaton. Deposts are defned as the sum of tme deposts and savngs, whereas real deposts are deflated by the avalable prce ndex. The coeffcent of the depost rate should have a postve sgn, snce a hgher return on deposts makes deposts more attractve. The return on government debt and the money market rate are the prces of two substtutes for deposts. They have negatve coeffcents, because the opportunty cost of holdng money n depost ncreases wth the prce of any one of the substtutes. Real gdp proxes ncome or wealth and should reflect the postve relatonshp between ncome and the propensty to save, or between wealth and nvestment. The coeffcent of unemployment wll be postve f the ncreased probablty of facng unemployment encourages savngs, but can also be negatve, f ds-savng supplements a declne n ncomes n the case of unemployment. Hence, a pror predctons about ts sgn cannot be made. A smlar concluson can be drawn for nonemployment, whch would be an alternatve to the unemployment varable (Blanchard, 2000, pp. 106 ff.). Nonemployment also takes nto account the effect of the prudental motves people lvng on benefts may have for savng money. The mpact of nflaton on the demand for deposts, too, can swng ether way. The drect effect of nflaton on deposts s negatve, the argument beng that hgher nflaton ncreases consumers propensty to spend money now rather than to engage n long-term nvestments. However, f the depost rate (almost) fully compensates for nflaton, the effect on deposts can also be postve, due to money lluson. The sgns of cross-term coeffcents are farly unpredctable, as they reflect non-lnear effects. 15 We have no a pror deas ether about the sgns of country dummy coeffcents or, n many cases, tme trend coeffcents, when and where they occur. Table 1 recaptulates the expected sgns of the coeffcents of the depost model and also presents the coeffcent sgns for the other models to be dscussed below. Prce equaton (11) determnes the depost rate as a functon of the volume of deposts, the man nput prce wage rate, other exogenous varables, such as nflaton and the markup functon,.e. output dvded by the frst dervatve of the demand functon wth respect to r dep. The coeffcent of the markup, -?, s the measure of depost market competton, whch we set out to fnd. For the coeffcent of the volume of deposts, we expect a negatve sgn, because banks wll pay a lower rate on deposts the more deposts they have already attracted. The coeffcent of wages of bank employees should also be negatve, as a hgher nput prce has a negatve mpact on the depost 15 Note that the sgns of cross-terms are dffcult to assess, as they consst of two terms, prce or nterest rate and demand factor. Furthermore, the respectve demand factor occurs twce, separately and multpled by the prce. The sgn of both coeffcents should be judged coherently.

13 13 rate. Consumers need to be compensated for nflaton by the depost rate. Therefore, ts coeffcent s expected to be postve. Table 1 Expected coeffcent sgns of the determnants of the varous models deposts depost rate loans lendng rate lagged endogenous depost rate + + gdp, real + + government rate + + money market rate + + consumer confdence + unemployment nonemployment nflaton + + cross-terms tme trend country dummes ntercept markdown/up (-? ) deposts wages, real + loan growth + lendng rate labour share utlsaton grade + loans, real + + Note: stands for a pror ndetermnacy. A few other explanatory varables whch do not drectly follow from the theoretcal framework above have also been consdered, such as alternatve nterest rates, whch act as a reference for the bank s depost rate, and loan growth or real loans, whch reflects the need for the bank to acqure fundng. These varables do not really conflct wth the theoretcal model for n fact takng deposts s not the sole fundng nstrument of the bank. 16 The alternatve nterest rates, the money market or government rate, are related to alternatve nvestment possbltes for the prvate sector and can not be gnored. Therefore, we expect postve sgns. Hgher than normal loan level or loan growth may encourage the bank to rase ts depost rate, n order to ncrease fundng. Agan, postve sgns would be plausble. EU-wde results The complete estmaton results for depost markets n the nne EU countres combned, as well as n each of these nne EU countres separately, are presented n Appendx 1. We frst dscuss the EU-wde estmaton results of the real depost equaton, see Table 1.1 n ths Appendx. Ths cross-secton and tme seres or panel data regresson s based on the sample wth the hghest nformatonal content, namely 774 observatons. At the same tme, such a model s restrctve, snce per varable dentcal coeffcents are assumed for all countres nvolved. In order to deal 16 Alternatves are the nterbank market (deposts) and the captal market (blls, bonds and shares).

14 14 wth possble autocorrelaton, we ncluded the lagged dependent varable and an autoregressve term n the error. The coeffcent of the lagged dependent varable has been set at 0.95 to avod a hgher and less plausble value. The estmaton results of ths equaton are condtonal on ths nterference. Such a hgh Koyck lag value ponts to a slow adjustment process, reflectng that real deposts s a stock varable. Furthermore, t ndcates that depost savng s, n part, based on certan consstent behavoural patterns (such as conservatve savng behavour, prce nsenstvty, rresponsveness to alternatve nvestment opportuntes), whch s not pcked up fully by the ncluded explanatory varables. Besdes, real deposts also nclude long-term tme deposts, whch are n part fxed by defnton. The autocorrelaton tests ndcate that the resultng errors are free of seral correlaton. All demand varables have sgnfcant coeffcents wth the rght sgns. 17 The cross-term s also sgnfcant. Together wth the coeffcent of the depost rate, ths coeffcent s mportant, as t consttutes the markdown varable n the depost rate equaton. Addng nonemployment to ths equaton would yeld a nsgnfcant coeffcent. Substtuton of unemployment by nonemployment would result n a lower level of sgnfcance. 18 Fve country dummy coeffcents show a sgnfcant devaton from the Dutch deposts level, 19 ndcatng a hgher (Belgum, France, Span and the UK) or lower (Sweden) savngs level, after takng the other varables nto account. Ths outcome reflects dfferences across countres and suggests that country-specfc estmates mght add new nsghts. The country dummes are jontly sgnfcant, as shown by the F-test n the bottom of Table 1.1. A second F-test reveals that the whole equaton s also jontly sgnfcant. We conclude that these estmaton results make a good bass to construct the markdown varable, as requred n the second equaton. Table 1.2 n Appendx 1 presents the EU-wde estmates of the depost rate equaton. As the autocorrelaton tests show mxed results whch ndcates possble seral correlaton n the errors, we have to rely on t-values, based on Newey and West s autocorrelaton consstent covarances. Ths equaton also ncludes a lagged dependent varable, but ts coeffcent ndcates a relatvely quck adjustment process. The major explanatory varable s the government rate wth a long-term coeffcent of 0.423/( ) = Ths s a plausble outcome: the depost rate s approxmately two-thrds of the government rate. Other margnal cost or supply varables have hardly any effect. In the centre of our nterest s the coeffcent? of the markdown, representng the banks (use of) market power n offerng depost facltes. Ths coeffcent s hghly sgnfcant, ndcatng, n prncple, absence of fully perfect competton and use of at least some market power, but ts value s small. Actually,? s so small that the observed use of market power 17 By sgnfcant (or very sgnfcant) we mean, n ths paper, at the 95% (or 99%) level of confdence. 18 We found smlar results for the sngle-country estmates, except for the UK where nonemployment was a better explanatory varable, see Table 1.1.a n Appendx The ntercept estmates the Dutch depost level, after takng the other varables nto account.

15 15 s vrtually neglgble. Apparently, the EU depost markets are charactersed by a hgh degree of competton. However, ths concluson may hold true only for the natonal or local markets. The fact s that we also observe dfferences n the level of the depost rates across the EU countres, as four country dummy coeffcents are sgnfcant. Probably, durng ths pre-euro perod under nvestgaton, cross-border competton on the EU depost markets has been lmted. Under a Cournot equlbrum,? s assumed to be equal to the recprocal of the total EU number of banks (? = 1/n), see above. 20 A test on? = 1/n makes clear that a Cournot equlbrum must be rejected. Actually, a test does not make much sense (on the EU level), now we have observed that the EU depost market s at least segmented nto natonal submarkets. Sngle-country results Table 2 summarses the estmated values of? for depost markets n the nne countres under consderaton. The table furthermore ndcates the number of observatons for each estmaton exercse and the respectve sample perods. The values for? n Cournot equlbrum ( λ =1 n, for n banks) are calculated for 1987 and 1997 on the bass of the number of banks obtaned from the OECD (1999). By the way, the fgures make clear that, over ths perod, the number of banks has declned consderably, by around 25%, llustratng the current and recent process of consoldaton n most EU countres. Table 2 Market power and summary of the estmates of the depost rate model No. of observatons Estmaton perod? a t-value No. of banks (1987) 1/n No. of banks (1997) EU wde 774 varyng b *** 5.2 7, , Belgum France :2-98: , , Germany :1-98: ** 2.2 4, , Italy :1-98: Netherlands :2-98: Portugal :1-97: a Span :3-97: ** Sweden :3-98: UK :3-98: Total 702 7,346 5,646 Note: See Tables 1.1 and 1.2 n Appendx 1. a A negatve value for? ndcates the exstence of a supra-negatve market condton. Ths s a non-equlbrum stuaton n whch bank output exceeds a compettve level and prces are too low, so that over tme output n these markets wll fall and wll prces rse; b By country. 1/n Apart from the depost rate, at least one cross-term varable proved sgnfcant n the real deposts equaton for each country, see Table 1.1 n Appendx 1. An excepton s Belgum, where nether the depost rate coeffcent nor the cross-term coeffcents are sgnfcant. For that reason we do not estmate a depost rate equaton for that country, unable as we are to determne a useful 20 The Cournot model assumes that a frm does not expect retalaton from other frms n response to

16 16 markdown. The man demand varable real gdp s sgnfcant wth the rght sgn n all countres. Also the government rate coeffcent has the rght sgn wherever t s sgnfcant. The sgn of the unemployment coeffcent dffers across countres, as expected. For the UK, nonemployment was a good alternatve for unemployment. The tests do not ndcate sgnfcant autocorrelaton problems n any of the countres consdered. The degree of ft the adjusted R² s satsfactory. Hence, these estmaton results consttute a good bass to construct the markdown varable, as needed n the second equaton. For most countres, the depost rate equaton s rather plan n the sense that the number of explanatory varables s low, see Table 1.2 n Appendx 1. Apart from, n a number of countres, the lagged dependent varable, ether the government rate or the money market rate s the man sgnfcant varable. In a few countres, the nput prce real wages s also sgnfcant. In these cases all sgns are n lne wth expectatons. The tests on autocorrelaton do not ndcate any problem n any country except Sweden, where we rely on Newey and West s autocorrelaton consstent covarances. The degree of ft s very satsfactory wth levels above 94% for all countres. Somewhat dsappontngly, the major output of the two depost market model equatons, the degree of competton?, s sgnfcantly only for Germany and Span, see also Table 2. For the other countres ths ndcates, n prncple, absence of the use of market power,.e. perfect competton. Note that we should keep n mnd that, snce the perfect competton hypothess (? = 0) s the null hypothess, the approach favours ths hypothess: a 95% level of sgnfcance s requred to reject perfect competton. For that reason we do not accept perfect competton (where? does not devate from zero) but consder both perfect competton and some knd of olgopoly wth hgh competton (ncludng Cournot equlbrum) as concevable. Furthermore, we cannot exclude the possblty that the Bresnahan approach mght not be senstve enough to measure market power accurately, gven the lmted number of avalable observatons on the country level and the possblty of trend breaks durng the lengthy observaton perods. For Germany and Span, we fnd at least nonperfect competton, but the use of market power s lmted. In the case of a Cournot equlbrum, we assume? = 1/n. In that respect, we note that the relevant number of banks, n, s not always known exactly. For nstance, there s a substantal dfference between the number of banks wth a bankng lcence and the number of actually actve banks. For Span the value of? s sgnfcantly below that of Cournot equlbrum, so we can reject the latter. For the other countres, t s less easy to draw a concluson, although values of? and 1/n make Cournot less lkely n Italy, the Netherlands, Portugal and the UK. For Germany, the value of? changes n ts own output.

17 17 appears to be somewhat hgher than 1/n, but we cannot reject the hypothess of a Cournot equlbrum. The Swedsh value of? s even equal to 1/n, as under Cournot, but gven the t-value of?, t s agan mpossble to reject e.g. perfect competton. Possbly, banks n Germany and Sweden (and n some of the other countres) do not expect retalaton from other banks as response to changes n ther own depost facltes output, as the Cournot model assumes. Under reservaton for possble nsenstvty of the Bresnahan approach, we draw the concluson that the markets for depost facltes n the EU countres consdered are most probably hghly compettve, as we found for the EU-wde sample. 2. The markets for loans The second market we nvestgate employng the Bresnahan model s the loan market. Quantty equaton (12) determnes the volume of real loans. The varable loans s negatvely related to ts prce, the lendng rate, and postvely related to ncreasng nvestment actvty as ndcated by a hgher real gdp ncome and a hgher captal utlsaton rate. Unemployment may be another ndcator of economc actvty or sentment, whch n addton reflects structural dsequlbrum. Its coeffcent s expected to be negatve. A hgh proft ncome share (or a low labour ncome share) ndcates hgh profts and favourable expectatons of future profts. Ths ndcates attractve nvestment opportuntes and, by mplcaton, ncreasng demand for new loans. On the other hand, f profts are hgh, new nvestment actvtes may also be fnanced nternally, weakenng the demand for loans. All n all, we have no way of knowng the sgn of the coeffcents of the labour share n advance. The propensty of economc agents to take out loans s encouraged when expected nflaton s hgher, so that the real value of funds decreases. Conversely, however, the lendng rate mght also rse on account of nflaton, cancellng out the effects. So the sgn of the nflaton coeffcent s ndetermnate. The expected sgns are summarsed n Table 1. Prce relatonshp (13) determnes the lendng rate by real loans, nput tems such as wages and the depost rate, as well as other exogenous varables such as the money market rate, the government rate, nflaton and the markup: output dvded by the frst dervatve of the demand functon wth respect to r lend. The coeffcent of the latter, -?, s the crucal varable n our analyss, the measure of compettve conduct on the loans market. As the value of? s expected to fall n the range of 0 to 1, -? wll be negatve. Banks are expected to translate the rsk assocated wth a larger loan portfolo nto a hgher lendng rate. Lkewse, ncreasng costs related to the provson of loans, namely hgher wages, and hgher costs of fundng ncrease the operatng costs of banks and wll probably be reflected n hgher lendng rates. The money-market rate and the rate on government debt were ncluded n the prce relaton as a comparatve measure for product prcng, and are expected to exert a postve nfluence on the lendng rate. In fact, they also reflect fundng cost, such as costs related to nterbank and captal market borrowng. Fnally, banks wll

18 18 take account of real losses assocated wth hgher nflaton by adjustng ther lendng rate accordngly. Hence, all coeffcents are expected to be postve, be t that we antcpate a negatve sgn for -?. EU-wde results The complete estmaton results for loan markets n the regon of nne EU countres, as well as n each of these nne EU countres separately, are presented n Appendx 2. We frst dscuss the EUwde estmaton results of the real loans equaton, see Table 2.1 n ths Appendx. In order to prevent possble autocorrelaton, we ncluded the lagged endogenous varable wth a coeffcent of 0.95, whch was fxed to avod a hgher and less plausble value. Other estmaton results of ths equaton are condtonal on ths nterference. Ths hgh Koyck lag value ponts to a slow adjustment process, whch s obvous, as real loans s a stock varable. The loans are of a shortterm and long-term nature, n some cases up to ten years and more. The loan volume of a country may also depend on certan consstent behavoural or omtted varables, whch are not pcked up fully by the ncluded explanatory varables. The autocorrelaton tests ndcate that the errors are free of seral correlaton. All major demand varables have sgnfcant coeffcents wth the rght sgns. The two cross-term coeffcents are also sgnfcant, whch s mportant as, together wth the coeffcent of the lendng rate, they consttute the markup varable n the lendng rate equaton. Fve country dummy coeffcents show a sgnfcant devaton from the Dutch loans level, ndcatng a hgher (Portugal and Span) or lower (France, Italy and Sweden) lendng level, after takng the other varables nto account. These dfferences across countres suggest that country-specfc estmates would be worthwhle. Both the country dummes and the whole equaton are jontly sgnfcant, as shown by the F-tests n the bottom of Table 2.1. Table 2.2 n Appendx 2 presents the EU-wde estmates of the lendng rate equaton. The test statstcs ndcate absence of autocorrelaton. Ths equaton does not nclude a lagged dependent varable. Apparently, the lendng rate adjusts wthn one quarter. The major explanatory varable s the government rate wth a coeffcent of Real loans s the only other margnal cost or supply varable wth a sgnfcant coeffcent. The crucal result s the parameter? of the markup, measurng the use of market power of EU banks n offerng loans. Ths coeffcent s sgnfcantly pontng to rejecton of perfect competton on the EU lendng markets. The value of? s larger than 1/n, as n the Cournot equlbrum, but the latter can not be rejected. Sgnfcant country dummy coeffcents ndcate dfferences n the level of the lendng rates across the EU countres. Ths underlnes the concluson above of less than perfect competton n the EU. Obvously, durng ths pre-euro perod under nvestgaton, cross-border competton on the EU loan markets has been lmted.

19 19 Sngle-country results Table 3 summarses the estmated values of? for loans markets n the nne ndvdual countres. Apart from the lendng rate, at least one cross-term varable proved sgnfcant n the real loans equaton for all countres, see Table 1.1 n Appendx 1. An excepton s the UK n the sense that ts lendng rate coeffcent s sgnfcant at the 94% level of confdence only, nstead of the 95% level. Nevertheless, we assume that for ths country also a meanngful markup may be constructed. The major demand varables, real gdp and unemployment, are sgnfcant wth the rght sgn n most countres. The respectve tests do not reveal sgnfcant autocorrelaton n any of the countres consdered. Table 3 Market power and summary of the estmates of the lendng rate model No. of obser- Perod? t-value Inverse of no. of banks (1/n) vatons EU-wde 718 varyng a ** Belgum :1-98: France :2-98: Germany :1-98: ** Italy :3-98: Netherlands :2-98: Portugal :2-97: ** Span :3-98: ** Sweden :1-98: ** UK :3-98: ** Total 711 a By country. Apart from the lagged dependent varable, one or more nterest rates the depost or fundng rate, on the one hand, and the government or money market rate as market rates on the other are the man sgnfcant varables n the lendng rate equaton, see Table 2.2 n Appendx 2. In a number of countres, the quantty real loans and the nput prce real wages are also sgnfcant, wth sgns n lne wth expectatons. Mxed evdence regardng autocorrelaton occurs for the UK only, where we rely on t-values, based on Newey and West s autocorrelaton-consstent covarances. The degree of ft s hgh wth R-squares above 95% for all countres, except Sweden (92%). The essental output of the two loan market equatons, the degree of competton?, s sgnfcantly n not less than fve countres: Germany, Portugal, Span, Sweden and the UK, see also Table 3. For the other countres, n prncple, ths suggests the absence of use of market power,.e. perfect competton or n any case a hgh degree of competton. 21 In Germany, Portugal, Span, Sweden and the UK we fnd nonperfect competton, but wth lmted use of market power only. For Germany, Portugal, Span and Sweden, the value of? appears to be

20 20 sgnfcantly smaller than accordng to the? value n Cournot equlbrum (? = 1/n), so we reject ths equlbrum for these countres. For the UK,? appears to be equal to 1/n, so that we cannot reject Cournot equlbrum. Apparently, banks n the UK do not expect retalaton from other banks as response to changes n ther own lendng output. For the other countres, a Cournot equlbrum s less lkely. Under certan reservaton, we draw the concluson that the loans markets n the EU countres nvestgated are most probably hghly (but not always perfect) compettve, as we found also for the EU-wde sample. 3. Earler applcatons of Bresnahan n the lterature The few exstng emprcal applcatons of the Bresnahan model to the bankng ndustry are dffcult to compare wth our results. 22 The model has been estmated by Shaffer (1989, 1993) for, respectvely, the US loan markets and for the Canadan bankng ndustry. In both cases, values of? were found to be not sgnfcantly dfferent from zero, mplyng perfect competton or Cournot olgopoly. Zardkooh and Fraser (1998) use the model to test whether geographcal deregulaton n the US had affected the market structure n the ndvdual states. Perfect competton was found n most states, but mperfect competton n the others. Rbon and Yosha (1999) nvestgated the hghly concentrated Israel bankng market and found sgnfcant but declnng market power n both the depost and loan markets. As far as we were able to fnd out, only three studes have appled the Bresnahan method to European banks, namely Suomnen (1994) to the Fnsh bankng depost and loan markets, Swank (1995) to the Dutch mortgage and savngs depost markets and Toolsema (2002) to the Dutch revolvng consumer credt market. Suomnen fnds estmates for?, whch are not sgnfcantly dfferent from zero for the years untl 1985, wth regulated nterest rates, and values of? ndcatng the use of market power after the deregulaton of the loan market. Swank used a dynamc verson of the Bresnahan model for the mortgage and savngs depost markets durng the years He detects that both markets under consderaton were sgnfcantly more olgopolstc than under Cournot equlbrum. However, the degree of market power on the mortgage market falls sharply over tme, beng close to zero n the years we nvestgate n ths study. Ths s n lne wth the vew that deregulaton over tme has contrbuted to less olgopoly. In Swank s study, the market power parameter on the depost market remans close to zero, although rsng slghtly over tme, owng to the ncreasng concentraton of (depost takng) banks. However, n more recent years, many new supplers of depost servces have entered the Dutch market. Toolsema (2002) employs monthly data of the consumer credt market over Note, once agan, that the employed approach s favourable for the perfect competton hypothess, as t s the null hypothess. 22 Bresnahan s model has also been appled to other ndustres, e.g. Alexander (1988), Graddy (1994), Genesove and Mulln (1998), Wolfram (1998) and Steen and Salvanes (1999).

21 Non of the varous specfcatons she tres provde sgnfcant values for?. So, she concludes that Dutch banks do not use market power on the consumer credt market. Our results from the Bresnahan model can be compared wth results from the P-R approach. Bkker and Groeneveld (2000) and Bkker and Haaf (2002 a ) found for most European countres that the entre bankng market was charactersed by monopolstc competton and for a few countres, they even observed perfect competton. The same concluson apples to submarkets of small, medum-szed and large banks. Bkker and Groeneveld (2000) also nvestgated the EU market as a whole, wth monopolstc competton as result. Smlar outcome have been found by other authors (for an overvew, see Table 4 n Bkker and Haaf, 2002 a ). Accordng to the Bresnahan model, for the depost and loan sub markets competton appears to be at least that heavy. Possbly, due to the lmted avalable data sets and the longer estmaton perods, wth rasng rsks of trend breaks, the Bresnahan model has more dffcultes n dstngushng between perfect competton and olgopoly or monopolstc competton than the P-R approach. IV. CONCLUSIONS Applcaton of Bresnahan s market power model ndcates a hgh degree of competton on both the depost and loan markets n the nne EU countres under consderaton, both apart and jontly. The hypothess of perfect competton (? = 0; no markup on the lendng rate or no markdown for the depost rate) can be rejected for the depost market of the entre EU, for the depost markets of Germany and Span and for the lendng markets of Germany, Portugal, Span, Sweden and the UK. Nevertheless, these markets are charactersed by hgh competton, as the use or abuse of market power s very lmted. In the other country-market combnatons, where we cannot reject perfect competton, we conclude that competton s hgh, leavng open the queston of whether these markets face perfect competton or a knd of olgopoly wth competton farly close to that. Ths assessment of hghly compettve bankng markets n EU countres for depost facltes and loans s n lne wth the results of the P-R model, whch also ndcates (at least) the exstence of monopolstc competton for almost all European countres and cannot reject perfect competton n some countres. For the depost markets of the entre EU and Span, and the loans markets of Germany, Portugal Span and Sweden, we can reject the hypothess of a Cournot equlbrum (? = 1/n). Also n a number of other country-market combnatons, such equlbrum s less lkely. An excepton s the loan market n the UK, where we cannot reject Cournot equlbrum. Apparently, banks n the UK do not expect retalaton from other banks n response to changes n ther own lendng output. Further, Cournot equlbrum s concevable n the depost markets of Germany and Sweden.