A.W.A. Boot

Can Relationship Banking Survive Competition

We develop a model of the banking firm that is intended to reflect contemporary trends in the evolution of banks. In particular, we focus on the effects of both interbank and capital market competition on the role of banks in funding corporations. In our model, banks can choose to provide loans that are similar to capital market funding (transaction loans) or loans that involve unique bank-specific services (relationship loans). Borrowers can choose one of these two types of bank loans or directly access the capital market. Our key result is that, contrary to what many believe, a bank’s optimal response to increased competition is to expand relationship lending relative to its transaction lending. The behaviour of the absolute level of relationship lending with respect to increasing competition is non-monotone. Initially, an elevation in competition leads to an increase in the expected level of relationship lending, but then the expected level of relationship lending falls as competition rises further. Moreover, the viability of relationship banking depends significantly on the reputational quality of banks.

MORAL HAZARD AND SECURED LENDING IN AN INFINITELY REPEATED CREDIT MARKET GAME

The authors analyze repeated moral hazard with discounting in a competitive credit market with risk neutrality. Even without learning or risk aversion, long-term bank-borrower relationships are welfare enhancing. The main result is that the borrower obtains an infinite sequence of unsecured loans at below spot market cost following the first good project realization. This contract produces first-best action choices. Prior to this stage, the borrower gets secured loans with above-market borrowing cost. The optimal contract thus displays a selective memory feature, taking only one of two forms at any given point in time, depending on prior history. Copyright 1994 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.

The economics of bank regulation

The authors review the economics of bank regulation as developed in the contemporary literature. They begin with an examination of the central aspects of modern banking theories in explaining the asset transformation function of intermediaries, optimal bank liability contracts, coordination problems leading to bank failures and their empirical significance, and the regulatory interventions suggested by these considerations. In particular, the authors focus on regulations aimed primarily at ameliorating deposit-insurance-related moral hazards, such as: cash-asset reserve requirements, risk-sensitive capital requirements and deposit insurance premia, and bank closure policy. Moreover, they examine the impact of the competitive environment (bank charter value) and industry structure (scope of banks) on these moral hazards. They also examine the implications of banking theory for alternatives to deposit insurance.

Secured Lending and Default Risk: Equilibrium Analysis, Policy Implications and Empirical Results

The authors examine collateral in a competitive equilibrium in which borrowers can choose hidden actions and may additionally possess hidden knowledge. Apart from explaining the widespread use of collateral despite deadweight costs, they show that an increase in the riskless interest rate causes equilibrium loan rates and collateral requirements to increase, a decline in the deadweight costs of collateral reduces the equilibrium collateral use under moral hazard, and an increase in the borrowers project size reduces equilibrium collateral use under moral hazard. Some of these predictions are tested and found to be supported by the data. Copyright 1991 by Royal Economic Society.

Megamergers and expanded scope: Theories of bank size and activity diversity

We point to the vast empirical literature in banking to argue that the current expansion of scale and scope in banking represents a puzzle. We then present two explanations that help us to understand why banks are getting bigger and doing more. Our explanations suggest that banks may be doing this to increase their shareholders’ wealth and/or merely to enhance the reputation of their management (CEOs). The latter could lead to herd behavior involving banks that increase size and scope despite a dissipation of shareholders’ wealth. Alternatively, increasing size and scope may oAer strategic benefits (and hence increase shareholder wealth) in an environment with suAcient profitability in current operations and substantial uncertainty about future core competencies. We explore conditions under which either one of these competing explanations may dominate. ” 1999 Elsevier Science B.V. All rights reserved.

Competition, risk neutrality and loan commitments

We rationalize fixed rate loan commitments (forward credit contracting with options) in a competitive credit market with universal risk neutraility. Future interest rates are random, but there are no transactions costs. Borrowers finance projects with bank loans and choose ex post unobseravable actions that affect project payoffs. Credit contract design by the bank is the outcome of a (non-cooperative) Nash game between the bank and the borrower. The initial formal analysis is basically in two steps. First, we show that the only spot credit market Nash equilibria that exist are inefficient in the sense that they result in welfare losses for borrowers due to the banks informational handicap. Second, we show that loan commitments, because of their ability to weaken the link between the offering banks expected profit and the loan interest rate, enable to the complete elimination of informationally induced welfare losses and thus produce an outcome that strictly Pareto dominates any spot market equilibrium. Perhaps our most surprising result is that, if the borrower has some initial liquidity, it is better for the borrower to use it now to pay a commitment fee and buy a loan commitment that entitles it to borrow in the future rather than save it for use as an inside equity in conjunction with spot borrowing.

European Lessons on Consolidation in Banking

Abstract Does Europe offer lessons for the consolidation in US banking? In this paper, it is argued that the political dimension in Europe has led to the protection of national flagships and consolidation mainly on a national scale. Lessons for the US are limited. Rather, the regional expansion observed in US banking may offer valuable lessons for imminent cross-border mergers in European banking.

Consolidation and Strategic Positioning in Banking with Implications for Europe

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Regulatory Distortions in a Competitive Financial Services Industry

This paper focusses on the interaction between regulation and competition in a simple industrial organization model. We analyze how regulation affects the profitability of financial institutions. We find that information asymmetries impose a heavy regulatory burden on the higher-quality banks, highlighting the importance of fine-tuning regulation. Our other main results point at the importance of a level playing field.

Expansion of Banking Scale and Scope: Don't Banks Know the Value of Focus?

This paper provides an explanation for the urge of banks to merge and expand scope. We build a model where bank activities evolve over time. Due to deregulation and technological advances, new opportunities become available, but the skill needed to exploit them effectively may be unknown. Early entry into these scope-expanding activities may have learning benefits that are manifested in discovery of the skill needed to operate effectively. This discovery permits more efficient production decisions and thus has value that is increasing in the strategic uncertainty about future skill that exists in the scope-expanding activity. Scope expansion may not always be optimal, however. The reason is that scope expansion requires irreversible investments before actual demand is known. This demand uncertainty means that losses are incurred when demand does not materialize and the irreversible investment is forsaken. To offset these losses, two conditions must be met. First, sufficiently high strategic uncertainty about future skills is necessary. Second, the existing commercial banking operations must be sufficiently profitable to give the bank the necessary ‘deep pockets’ to absorb these losses. The latter suggests that banking may not be too competitive, and could point to a benefit of merging insofar as mergers reduce competition and deepen the banks’ pockets. Moreover, a merged entity may acquire the necessary skill for the future opportunity with higher probability than either of the merging partners on their own. This may elevate the benefits of merging further.