The Price-Concentration Relationship in Banking

Author(s): Allen N. Berger and Timothy H. Hannan

Source: The Review of Economics and Statistics, Vol. 71, No. 2 (May, 1989), pp. 291-299
Published by: The MIT Press
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 THE PRICE-CONCENTRATION RELATIONSHIP
IN BANKING
AllenN. BergerandTimothyH. Hannan*
A bstract-The commonly observed positive correlation be-
tween market concentration and profitability may be explained
by non-competitive pricing behavior, as argued by the struc-
ture-performance hypothesis, or by the greater effiency of firms
with dominant market shares, as argued by the efficient-
structure hypothesis. By examining the price-concentration re-
lationship instead of the profit-concentration relationship, this
paper tests the structure-performancehypothesis in a manner
that excludes the efficient-structurehypothesis as an alternative
explanation of the results. The results strongly support the
structure-performance hypothesis and are robust with respect
to model specification, measurement of concentration, and
econometric technique.
I. Introduction
N UMEROUS studies find a positive statistical
relationship between market concentration
and measures of firm or industry profitability. An
important debate has arisen over the underlying
causes of this relationship. The traditional struc-
ture-performance hypothesis suggests that this
finding reflects the setting of prices less favorable
to consumers in more concentrated markets as a
result of collusion or other forms of non-competi-
tive behavior.
A challenge to this interpretation is the effici-
ent-structure hypothesis posited by Demsetz
(1973), Peltzman (1977) and others. This argument
maintains that differences in firm-specific effi-
ciencies within markets create unequal market
shares and high levels of concentration. In princi-
ple, firms in markets with a large dispersion of
efficiencies could be either more or less efficient on
average than firms in other markets. However,
proponents of the efficient-structure hypothesis
usually assume (explicitly or implicitly) that the
dispersion of efficiencies within markets that cre-
ates high levels of concentration also results in
greater than average efficiency in these markets,
yielding a positive profit-concentration relation-
ship. In effect, it is maintained that higher than
Received for publication April 8, 1988. Revision accepted for
publication August 22, 1988.
* Board of Governors of the Federal Reserve System.
We are grateful to Dean Amel, Bob Avery, Michael Bradley,
Sally Davies, Doug Evanoff, Alton Gilbert, Dave Humphrey,
Nellie Liang, Steve Sharpe, and the anonymous referees for
helpful comments, and to Chris Trojan, Oscar Barnhardt, and
Roberto Sella for valuable research assistance. The opinions
expressed are those of the authors and do not necessarily
reflect those of the Board of Governors or its staff.
Copyright ? 1989
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average concentration is more often due to the
high market shares of firms that are efficient than
to the low market shares of firms that are ineffi-
cient. Otherwise, profits and concentration would
not be positively related.
Thus, the structure-performancehypothesis and
the usual form of the efficient-structurehypothesis
imply an observationally equivalent relationship
between concentration and profits, but differ as to
the structural model creating it. Essentially, the
structure-performance hypothesis takes concen-
tration as exogenous and maintains that high con-
centration allows for noncompetitive behavior
that results in less favorable prices to consumers
and higher profits to firms. The usual form of
the efficient-structure hypothesis, however, takes
firm-specific efficiencies as exogenous and main-
tains that these efficiencies result in both more
concentrated markets and higher profits. Clearly
an important public policy question is at stake in
this debate, since the structure-performance hy-
pothesis suggests that antitrust or regulatory ac-
tion may be productive, while the efficient-struc-
ture hypothesis suggests that such actions are likely
to be counterproductive.
This debate is no less pronounced in the litera-
ture that focuses on the banking industry, where
the existence of geographically limited markets
offers researchers the advantage of comparing
profitability and concentration across markets
without the confounding influences of interindus-
try differences.' Recent attempts to distinguish
empirically between the two competing hypothe-
ses by controlling for the effects of market share
on the profit-concentration relationship have not
met with mutually agreed upon success.2
1
For extensive reviews and opposing views of this literature,
see Rhoades (1982) and Gilbert (1984).
2
Market share has been included in profit-concentration
regressions using both banking data (e.g., Evanoff and Fortier
(1988) and Smirlock (1985)) and interindustry data (e.g.
Smirlock, Gilligan, and Marshall (1984)), and its inclusion has
been found to diminish substantially the effect of concentra-
tion on profits. Whether or not this finding supports the
efficient-structure hypothesis rests on the disputed contention
that market share proxies only the effects of the efficiency of
larger firms and not their market power. See Shepherd (1986)
and the reply by Smirlock, Gilligan, and Marshall (1986).
[ 291 1
292 THE REVIEW OF ECONOMICS AND STATISTICS
In this paper, we approach this issue by avoid-
ing the use of profit data altogether and employ-
ing in its place the extensive information on prices
collected in Federal Reserve System surveys of
banking institutions. This allows us to exploit
important differences in the price-concentration
relationship implied, by the two hypotheses. As
argued below, the structure-performancehypothe-
sis predicts that prices will be less favorable to
consumers in concentrated markets because of the
non-competitive behavior exhibited in such mar-
kets. In contrast, the usual form of the efficient-
structure hypothesis predicts that prices will, if
anything, be more favorable to consumers in con-
centrated markets because of the greater efficien-
cies exhibited in such markets. Thus, the use of
survey price data allows a test of the structure-per-
formance hypothesis that excludes the usual form
of the efficient-structure hypothesis as an alterna-
tive explanation of the results.
The empirical results are found to be consistent
with the implications of the structure-performance
hypothesis and are robust with respect to model
specification, measurement of concentration, and
econometric method.3 The change over time in the
price-concentration relationship is also briefly dis-
cussed.
II. Model Specification
Since the most extensive survey information
available on bank pricing behavior refers to the
interest rates banks offer for retail deposits, the
empirical analysis focuses on the role of local
market concentration as a determinant of these
rates. The tests reported below are relatively
straightforward. They consist of estimating re-
duced-form price equations of the form:
rijt = a + 3CONCj, + 7yxij, + Eijt, (1)
where rij, represents the interest rate paid at time
t on one category of retail deposits by bank i
located in local banking market j. CONCIt de-
notes a measure of concentration in local market
3 The few previous studies of the price-concentration rela-
tionship in banking found support for the structure-perfor-
mance hypothesis, although the data used in these studies were
usually limited in scope and pre-dated by many years to-
day's deregulated pricing environment (see Edwards (1964),
Glassman (1975), Heggestad and Mingo (1976), and Hannan
(1979)). A recent exception is Keeley and Zimmerman (1985),
which reported mixed results with a limited sample.
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j at time t, and xi]t denotes a vector of control
variables that may differ across banks, markets, or
time periods. These control variables include fac-
tors exogenous to the bank that may affect prices
through market conditions or cost considerations.
Coefficients are represented by a, f8, and -y, while
cijt denotesthe errorterm.
The structure-performance hypothesis implies
that market concentration results in prices less
favorable to consumers. Since the prices employed
here (deposit interest rates) are paid to consumers
rather than by consumers, this hypothesis implies
a negative price-concentration relationship, or
/3 <0.
The usual form of the efficient-structurehypoth-
esis, however, maintains that because of the domi-
nance of efficient firms in concentrated markets,
production in such markets is more efficient on
average. To the extent that greater efficiency is
reflected in a lower marginal cost of producing
output of a given quality, firms in concentrated
markets should find it in their interests to offer
consumers more favorable prices, higher quality,
or both.4 Put into the context of our banking
application, if banks in concentrated markets are
more efficient on average in gathering deposit
funds and transforming them into profitable in-
vestments, the marginal dollar of deposits should
have more value to them. Thus they should, if
anything, bid more for deposits, implying a posi-
tive price-concentration relationship, or ,B 2 O.'
The choice of an appropriate measure of bank-
ing market concentration (CONC) is made diffi-
cult by the fact that theory provides little guidance
in suggesting which measure to employ when the
type of non-competitive behavior at issue is un-
' We exclude from consideration the possibility that greater
efficiency results in less favorable prices to consumers accom-
panied by more than compensating increases in quality. In a
competitive market, this requires either (i) that money income
is an inferior good so that firms find it in their interest to bid
for consumer patronage with more quality and less money
income, or (ii) that the gain in efficiency of firms in concen-
trated markets is heavily biased toward quality improvements
as opposed to cost reductions. Neither of these seems particu-
larly plausible for the bank accounts considered here, where
quality differentials are fairly narrowly constrained by law.
SNote that the efficient-structure hypothesis could predict
fi < 0 if concentration results from the inefficiency of small
firms in the market, rather than the efficiency of large firms. In
this case, however, concentration would be associated with less
efficiency, violating the observed positive profit-concentration
relationship. We therefore rule out this "unusual" form of the
efficient-structure hypothesis as an explanation of a finding of
A < 0.
 THE PRICE-CONCENTRATION RELATIONSHIP IN BANKING 293

known.6 To determine whether the results are results are based contains 470 banks in 195 local
sensitive to the choice of measure, we employ both banking markets observed quarterly over a 2-1/2
the three-firm concentration ratio (CR3) and the year period. When cross section data from ten
Herfindahl index (HERF) in the empirical analy- quarters are pooled in estimation, roughly 3,500 to
sis. The variables CR3 and HERF are also con- 4,000 observations are employed for each of six
structed both with and without the inclusion of different deposit categories.
savings and loans (S & Ls), which offer similar Table 1 gives the definitions of the variables.
services. All four measures yield qualitatively simi- The dependent variables are retail deposit interest
lar results. rates (expressed in basis points) paid by commer-
Additional variables are included for the pur- cial banks, as reported in the Federal Reserve's
pose of statistical control. The growth rate of Monthly Survey of Selected Deposits and Other
deposits in the bank's market (IYRGROW) may Accounts. Six rates are collected: the Money Mar-
reflect local demand or supply considerations, and ket Deposit Account (MMDA) rate (rmmda), the
its coefficient may have either sign. The variable Super-NOW (SNOW) rate (rs) and the 3, 6,
BANKPROP, defined as the number of bank 12, and 30 month Certificate of Deposit (CD)
branches divided by total bank plus Savings and rates for accounts under $100,000 (rcd3m, rcd6m,
Loan (S&L) branches in the local market, is an rcdl2m, rcd30m). The MMDA and SNOW rates
inverse index of the extent to which S & Ls com- were collected for each of ten quarters from
pete with banks and is predicted to have a nega- September 1983 to December 1985. The CD rates
tive coefficient.7 Local per capita income were collected for the latter nine quarters, since
(PCINCOME) is included to control for factors these rates were not yet deregulated in September
affecting the supply of funds to banks. Its coeffi- 1983.
cient -may have either sign in a non-competitive Banks in the sample were assigned to local
market, since it may reflect either a greater or markets, which are defined as Metropolitan Statis-
lesser elasticity of deposit supply. The local bank tical Areas (MSAs) or non-MSA counties, follow-
wage rate (WAGE) is included as a cost factor. ing previous research (e.g., Smirlock (1985) and
However, since it may also reflect local income Rhoades (1982)). Banks with less than 75% of
differences across markets, the sign of its coeffi- their deposits in one local market were deleted
cient is not predicted. Similarly, the variable MSA from the sample to ensure a close correspondence
reflects the differences in conditions between between the deposit rates banks offer and the
metropolitan and rural markets, and its coefficient characteristics of the markets in which they oper-
may have either sign. The variables UNIT and ate, although virtually equivalent results are ob-
LIMIT indicate whether the state in which the tained in the absence of this restriction.8
bank is located prohibits or limits branch banking,
respectively. To the extent that these variables IV. EmpiricalResults
signal effective entry barriers, negative coefficients
Tables 2 and 3 report results obtained by re-
are predicted.
gressing retail deposit rates on a measure of con-
centration and various control variables. Since all
III. Data Description and Sources four concentration measures (CR3 and HERF,
The data employed in this study are quite exten- each with and without the inclusion of S& Ls)
sive. The refined sample upon which reported yield qualitatively similar results, we report only
those results obtained by using CR3 computed for
6
Dansby and Willig (1979) give the theoretical rationales for
banks only. We focus primarily on the MMDA
various market concentration measures when the type of con-
jectural variations that firms hold are known. The Herfindahl 8 The concentration measures (CR3, HERF) are calculated
index is implied for Cournot competitors, and the m-firm using Summary of Deposits data for banks and (when applica-
concentration ratio is implied when the largest m firms collude ble) Federal Home Loan Bank Board data for S & Ls. Market
and the remaining firms are price-takers. We have no prior growth (1YRGROW) is constructed using the total deposits
grounds for choosing between these types of conjectural varia- (from the Report of Condition) of all banks with at least 75%
tions. of their deposits in one market (as determined from Summary
7 The alternative of using bank and S & L deposits rather of Deposits data). Bank wages (WAGE) and per-capita income
than branches to construct this index was not chosen because (PCINCOME) are computed from County Business Patterns
of the greater likelihood of simultaneous equations bias associ- and Survey of CurrentBusiness, respectively. UNIT and LIMIT
ated with the use of deposit data. are formed using state branching laws as of 1984.

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294 THE REVIEW OF ECONOMICS AND STATISTICS

TABLE 1.-VARIABLE DEFINITIONS

Endogenous Variables (r)

rmmda -Money Market Deposit Account rate paid on the largest dollar value of
deposits issued during the 7-day period ending on the last Wednesday of
the quarter, 1983: 09-1985 :12. (basis points).
rsnow -Super-NOW rate for same periods.
rcd3m, rcd6m, rcdl2m, rcd3Om-3, 6, 12, and 30 month CD rates, beginning 1983 :12 (after
deregulation).
Exogenous Variables of Interest (CONC)
CR3 -3-firm deposit concentration ratio computed for commercial banks in the
local market (MSA or non-MSA county). Alternatively computed inclusive
of S & Ls as well as banks. (percent)
HERF -Herfindahl index of bank concentration, defined as the sum of squared
market shares of deposits. Alternatively computed inclusive of S & Ls as
well as banks. (sum of percent squared).
Exogenous Control Variables (X)
T8309-T8512 -Time dummies introduced to account for the interest rate cycle, changes in
minimum balance requirements, and other time-specific factors.
rmmmf -Money Market Mutual Fund rate, included instead of time dummies in
some estimations. (basis points)
1YRGROW -1-year growth in market deposits. (proportion)
BANKPROP -(Number of bank branches)/(Number of bank branches + number of
S & L branches) in the market.
WAGE -Index of local banking wage rate. ($000/quarter)
PCINCOME -Per-capita income in local market. ($ / year)
MSA -Dummy variable indicating location in a Metropolitan Statistical Area.
UNIT, LIMIT -Dummy variables indicating location in a unit banking or limited branch-
ing state, respectively.
Variables of Questionable Exogeneity (Excluded from X in most estimations)
MKTSHR -The bank's market share of deposits. (proportion)
BRANCH -Number of branches of the bank.
TA -Total assets of the bank.

rate, since MMDAs are predominantly local prod-
ucts with quite narrowly constrained quality dif-
ferences. Over the sample period, MMDAs had
standardized minimum balance requirements and
per-month transactions limits, reducing the possi-
bility that differences in service across banks can
explain differences in deposit rates.9 The SNOW
accounts had the same minimum balance require-
ments, but variations in per-check charges and
other fees might distort the regression results. The
CD accounts had very uniform service and charges,
but these accounts may be competed for on a
broader geographic basis than local markets, due
to larger denominations and less frequently re-
quired contact between depositor and bank.
Table 2 reports results obtained by estimating
equation (1) using the bank's MMDA rate as the
9 The legally binding minimum balance requirement was
$2500 through 1984 and $1000 in 1985. Throughout the sam-
ple, MMDAs could have no more than 6 preauthorized, auto-
matic, or other transfers per month, of which no more than 3
could be by check. It is possible that some banks imposed
stricter limits.
dependent variable. Ten quarterly cross sections
of 470 banks are pooled, with some of the banks
having missing data for some time periods. One
estimation problem concerns the possibility of
correlations among the error terms for banks
and/or markets that are included in the survey for
multiple quarters. In addition, the error terms are
likely to be heteroskedastic over time, since much
of the variation in retail deposit rates derives from
the interest rate cycle. To solve these problems, we
estimated by ordinary least squares (OLS) and
corrected the covariance matrix of the parameter
estimates by forming an unrestricted probability
distribution for each of the 470 banks from the
exogenous variables and OLS residuals.10
10
Details are available from the authors. In most cases, this
procedure yields standard errors 50% to 100%larger than those
calculated by the OLS formula. Computation of probability
distribution by market instead of by bank (not shown) did not
change the significance test results. Correction of the OLS
coefficient covariance matrix was chosen over use of GLS
because estimates of the error distribution by bank were judged
to be too tentative to use in altering the coefficient estimates.

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 THE PRICE-CONCENTRATION RELATIONSHIP IN BANKING 295

TABLE2.-MMDA RATE REGRESSIONS-POOLED TIME SERIES-CROSSSECTION

(DEPENDENTVARIABLE= rmmdaIN BASIS POINTS)

Exogenous
Variables (1) (2) (3) (4) (5)

CONSTANT 695.2b 684.8b 685.9b 689.7b 86.6a

(29.9) (28.4) (28.4) (26.2) (2.26)
CR3 0.63b 1.04a
(-5.72) (2.10)
CR3 - T8309 -0.33a 0.42b -0.38a
(-2.56) (-3.01) (-2.31)
CR3 - T8312 0.4ob 0.49 -0.44b
(3.65b (-4.12b (-2.95)
CR3 * T8403 -0.51 -0.61 0.56b
(-3.85) (-4.21) (-3.24)
CR3 * T8406 1.07 -1.17 -1.12
(6.01b (6.21) (- 5.40)
CR3 - T8409 -1.33 L.-1.374b
(-6.74b (-6.80) (- 6.18b
CR3 * T8412 -0.78 -0.87 -0.82
(-4.97) 5.33) (-4.53b
CR3 * T8503 -0.53 0.64 -0.58
(-3.71) (-4.24) (-3.36)
CR 3 * T8506 -0.46b 0.57b 0.50
(-2.92) (-3.48) (-2.802
CR3 * T8509 0.46 0.57b -0.51
(-3.30) (-3.84) (-2.92)
CR3 * T8512 0.45b 0.56b 0.50b
(-3.14) (-3.78) (-2.97)
IYRGROW 41 42.8 44.36 42.69b 49.32b
(3.86) (4.00) (4.14) (3.95) (4.29)
BANKPROP 8.24 8.58 7.91 8.24 9.64
(0.54) (0.56) (0.52) (0.52) (0.62)
WAGE 7.11 7.17 6.98 7.00 7.47
(4.20) (4.23) (4.03) (4.01) (4.23)
PCINCOME -0.001 -0.001 -0.001 -0.001 -0.001
(-0.95) (-1.00) (-0.82) (-1.11) (-1.27)
MSA -10.10a -9.98 -10.19a -9.59 -9.89
(-1.98) (-1.96) (-1.98) (-1.86) (-1.86)
UNIT -5.14 -4.94 -3.74 -3.19 -4.53
(-1.31) (-1.26) (-0.93b (-0.23) (-1.15)
LIMIT -11.79 -11.75 -12.01 -19.13 -11.49
(-3.32) (-3.32) (- 3.38) (-1.53) (-3.25)
MKTSHR 29.78a
(2.09)
BRANCH 0.05
(1.29)
CR3* UNIT -0.03
(-0.12)
CR3 * LIMIT 0.12
(0.60)
rmmmf 0.87b
(25.38)
CR3 rmmmf -0.002
(-3.44)
T8309-T8509 c c c c

R2/Num. Obs. 0.80/4047 0.80/4047 0.80/4047 0.80/4047 0.76/4047

a
Significantly different from zero at 5% level (t-statistics in parentheses).
b
Significantly different from zero at 1% level (t-statistics in parentheses).
c Time dummies T8309-T8509 were included in the first 4 regressions (T8512 excluded as base case).

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296 THE REVIEW OF ECONOMICS AND STATISTICS

TABLE3.-REGRESSIONS FOR OTHER INTERESTRATES-

POOLEDTiMESERIES-CROSSSECTION

Exogenous
Variables rsnow red3m rcd6m redl2m rcd3Om

CONSTANT 663.7b 687.8b 769.7b 776.0b 718.8b

(19.7) (20.0) (34.9) (15.5) (12.4)
CR3 - T8309 -0.39a
(-2.04)
CR3 * T8312 -0.48 0.46b 0.37 -0.55 -0.05
(-2.67) (-2.63) (-2.64) (-1.60) (-0.31)
CR3 * T8403 -0.38 -0.12 -0.10 0.06 0.32a
(-1.86) (-0.612 (-0.64b (0.18) (2.00)
Cr3 T8406 -0.75 0.71 -0.81 -0.68 -0.01
(-3.05) (-2.97) (-4.58) (-1.77) (-0.07)
CR3 * T8409 -0.89b 0.79b -.90b -0.63 -0.35
(-3.35) (-3.05) (-5.01) (-1.67) (-1.84)
CR3 * T8412 -0.84 -0.36 -0.43a -0.41 -0.06
(-4.03) (-1.95) (-2.59) (-1.48) (-0.33)
CR3 * T8503 -0.56 0.05 -0.40 -0.09 0.11
(-2.942 (0.29) (-2.90) (-0.30) (0.67)
CR3 * T8506 -0.61 -0.14 -0.31a -0.28 -0.22
(-3.042 (-0.87) (-2.38) (-1.03) (-1.09)
CR 3 * T8509 -0.51 0.46 0.49 0.36 0.36
(-2.64) (-2.59) (-4.12) (-1.48) (0.65)
CR3 * T8512 0.60b 0.54b 0.59b 0.42 -0.26
(-3.17, (-2.76) (-4.69) (-1.66) (-1.34)
IYRGROW 50.14 39.18a 27.1 13.39 83.04
(2.75) (1.99) (2.81) (0.51) (1.77)
BANKPROP 12.87 34.51 3.24 12.42 38.34
(0.55) (1.48) (0.21) (0.44) (1.40)
WAGE 1.99 3.77 3.53a 9.53a 8.93a
(0.70) (1.07) (2.21) (2.41) (2.07)
PCINCOME - 0.03b 0.0002 - 0.001 - 0.005 0.0009
(-2.61) (0.11) (-1.16) (-1.48) (0.70)
MSA -8.18 -8.03 -12.87 b 14.45 13.24a
(-1.11) (-1.21) (-3.32) (1.31) (2.03)
UNIT 1.81 13.18 6.19 12.43 9.08
(0.31) (1.59) (1.30) (1.43) (1.30)
LIMIT -3.04 -1.19 -3.24 6.09 9.51
(-0.59) (-0.22) (-0.92) (0.74) (1.04)
T8312-T8509 C C c C C

R2/Num. Obs. 0.51/3663 0.68/3436 0.88/3635 0.58/3466 0.33/3572

a
Significantly different from zero at 5% level (t-statistics in parentheses).
b
Significantly different from zero at 1% level (t-statistics in parentheses).
c Time dummies T8312-T8509 (plus T8309 for r were included in all regressions (T8512 excluded as base
case).

The regression reported in column (1) of table 2
includes as regressors CR3 and seven control vari-
ables (IYRGROW, BANKPROP, WAGE, PCIN-
COME, MSA, UNIT, and LIMIT). Fixed-effects
time dummies (T8309 to T8509) are also included
to account for the influence of the interest rate
cycle, the change in legal minimum balance re-
quirements for MMDAs (from $2500 to $1000 in
January 1985), and other possible changes in the
MMDA market over the sample period.
The concentration variable (CR3) coefficient is
negative and statistically significant at the 1%level.
With rmmda expressed in basis points and CR3
expressed in percentage points, the coefficient of
-0.63 implies a 47 basis point reduction in r
in moving from the least concentrated market in
the sample (CR3 = 25) to the most concentrated
market in the sample (CR3 = 100), ceterisparibus
(- 0.63 (25 - 100)= 47).11 Similarly, when
HERF is used in place of CR3 (not shown), the
predicted reduction is 52 basis points. The coeffi-
cients of the control variables reported in tables 2
11 A one standard deviation increase in CR3 (17 percentage
points) yields an 11 basis point reduction in rmmda, ceteris
paribus.

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 THE PRICE-CONCENTRATION RELATIONSHIP IN BANKING
and 3 are largely unexceptional and will not be
discussed due to space limitations."2
The finding that banks in more concentrated
markets pay lower deposit rates is consistent with
the implications of the structure-performancehy-
pothesis, but is not a prediction of the usual form
of the efficient-structure hypothesis. Thus, while
both efficiency and market structure effects may
play roles in explaining profitability, the results
presented here suggest the dominance of struc-
ture-performance hypothesis over the efficient-
structure hypothesis in determining deposit rates.
This same regression equation (without the time
dummies) was also estimated by OLS separately
for each of the ten quarters (not shown). The
coefficients of concentration were found to be
negative for every period and significant at the 1%
level in all but the first period, when rates on
competing deposit categories were not yet deregu-
lated. The levels of these coefficients also varied
considerably over the sample, rising from Septem-
ber 1983 to peak in September 1984 and then
falling through 1985.
A pooled time series, cross section regression
that allows the coefficients of CR3 to vary over
time (by including interactions of CR3 with the
time dummies) is reported in column (2) of table
2. The CR3 interaction coefficients are all statisti-
cally significant and follow the same pattern as the
separate cross-section estimates. The null hypothe-
sis that all ten CR3 coefficients are equal is re-
jected at the 1% level (X2 = 41). The fall in rmmda
in moving from the least to the most concentrated
market, ceteris paribus, rises from 25 basis points
in September 1983 to 100 basis points in Septem-
ber 1984, then falls to 34 basis points in December
1985. The use of HERF in place of CR3 (not
shown) and the inclusion of squared concentration
terms to account for the possibility of non-linear
relationships (not shown) does not alter the results
in any material way.13
12 The negative coefficient of MSA does not imply that
metropolitan area banks pay less than rural banks. In fact,
banks in MSAs pay higher MMDA rates on average (8.01%vs.
7.91%). The coefficient is hegative because the differences in
the other exogenous variables between urban and rural mar-
kets, particularly the lower concentration in urban markets,
would predict that an even larger premium be paid by urban
banks.
13 When interactions between the square of CR3 and the
time dummies are included, the derivative of rmmda with
respect to CR3 evaluated at the mean remains negative and
largely unchanged for each of the 10 time periods.
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297
The regression reported in column (3) tests the
robustness of our results to the inclusion of two
variables of questionable exogeneity-the bank's
market share (MKTSHR) and the number of of-
fices of the bank (BRANCH). Market share has
been included in some profit-concentration studies
as a proxy for firm-specific efficiencies, although it
may also capture elements of market power (see
Shepherd (1986)). Its use in a price-concentration
study is more problematic. Market share may be
highly endogenous to prices, since firms offering
more favorable prices to consumers may attract
customers and gain share. Moreover, if other mar-
ket conditions (including concentration) are prop-
erly controlled for, MKTSHR should only cause
differences in prices to the extent that it reflects
product quality differentials. Otherwise, con-
sumers in the same market environment would be
paying different prices for a product of the same
quality. For these reasons, MKTSHR is excluded
from most of the regressions. The significant posi-
tive coefficient of MKTSHR in column (3) could
indicate that firms of different sizes provide dif-
ferent levels of quality. However, this coefficient
could also reflect the endogeneity of MKTSHR if
banks that pay higher rates gain market share."4
Of primary importance, however, is the fact that
the inclusion of MKTSHR as a regressor in col-
umn (3) or in any of the other regressions (not
shown) does not change the finding of a significant
negative relationship between concentration and
deposit rates.
The variable BRANCH is included to control
for the possibility that local convenience may serve
as a substitute for higher deposit rates, implying a
negative coefficient for this variable. However,
since it is a decision variable for the bank, it is
excluded from most of the regressions to avoid
endogeneity. The insignificant positive coefficient
is not consistent with the hypothesis that branches
provide a strong service alternative to higher de-
14
It might be argued that a similar endogeneity problem
applies to the concentration measures (CR3, HERF) or the
market growth variable (IYRGROW), since they are con-
structed from the output of individual firms in the market.
However, any such problems are likely to be small, since
changes in one firm's deposit rate would generally have a small
effect on the entire market's concentration or growth. More-
over, any biases on the coefficient of the concentration measure
would tend to cancel each other out, since the change in a
firm's market share resulting from a price change would move
concentration in the same direction as market share for larger
firms and in the opposite direction for smaller firms.
298 THE REVIEW OF ECONOMICS AND STATISTICS
posit rates and may instead reflect the endogeneity
of this variable.'5 The inclusion of another poten-
tially endogenous variable, bank size as measured
by total assets (not shown), was found to make no
material difference to the registered effect of con-
centration.
The regression reported in column (4) includes
interactions of CR3 with both UNIT and LIMIT
in order to allow the effects of concentration to
vary across branching environments. The coeffi-
cients of these interaction terms are small and not
statistically significant (X2 = 0.5), and their inclu-
sion does not alter the role of market concentra-
tion in any material way.
Table 3 reports the results of regressions in
which the dependent variables are the five other
retail deposit rates taken from the survey. Each
specification is identical to that reported in col-
umn (2) of table 2 except for the dependent vari-
able. Note that the results of the r regression
are very similar to those reported for rmmda, except
that the variation over time in the CR3 coeffi-
cients is less pronounced. The regressions using
the shorter-term CD rates (rcd3m and rcd6m) have
some large and significantly negative CR3 coeffi-
cients, but a few of these coefficients are insignifi-
cant. Regressions using the longer-term CD rates
(rcdl2m and rcd3om) register mostly negative but
insignificant coefficients of CR3. These results are
consistent with the notion that CDs, particularly
those with longer maturities, are competed for on
a broader basis than that represented by local
banking markets.
Finally, we consider the possible causes of the
variation over time in the relationship between
deposit rates and concentration. As noted above,
the estimated effect of concentration increases
from September 1983 to September 1984 and then
falls through 1985. This roughly parallels the
movement in aggregate interest rates over the same
period. To examine how closely aggregate rates
track the deposit rate-concentration relationship,
the MMDA rate regression was re-run with the
Money Market Mutual Fund rate (rmmmf)substi-
tuting for the time dummies. As shown in column
(5) of table 2, this equation has almost the same
explanatory power (R2 = 0.76) as the models with
15
This coefficient could, for example, reflect the possibility
that banks that pay higher deposit rates attract more customers
and therefore decide to open additional branches.
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the time dummies (R2 = 0.80). In addition, plug-
ging the values of rmmmfinto this equation and
solving for estimates of drmmda/dCR3 reveals
roughly the same deposit rate-concentration pat-
tern over time as was registered with the time
dummies.16 The inclusion of additional lags for
the MMMF rate and allowing for different re-
sponses to upward and downward aggregate inter-
est rate movements did not change these results
substantially."7
The finding that the price-concentration rela-
tionship is stronger when aggregate rates are rela-
tively high may suggest slower price adjustment
on the part of banks in more concentrated mar-
kets, as implied by the "administered price" hy-
pothesis.18 This inference, however, is more tenta-
tive than those drawn above, since the data from
only one interest rate cycle are employed and
other macroeconomic events affecting the price-
concentration relationship may be correlated with
this cycle. A more extensive examination of the
variation in the deposit rate-concentration rela-
tionship over the interest rate cycle may provide a
fruitful avenue for future research.
V. Conclusions
This paper employs extensive information on
bank deposit prices to test the structure-perfor-
mance hypothesis in a manner that excludes as an
alternative explanation the form of the efficient-
structure hypothesis that is used to explain the
positive relationship between profits and concen-
tration. The empirical results are strongly consis-
tent with the implications of the structure-perfor-
mance hypothesis. Ceteris paribus, banks in the
most concentrated local markets in the sample are
found to pay MMDA rates that range from 25 to
100 basis points less than those paid in the least
concentrated markets, depending on the time pe-
16 This derivative is the CR3 coefficient (1.04) plus the prod-
uct of the interaction coefficient (- 0.002) and the appropriate
value of rmmmf-
17 This approach is similar to that of Domowitz, Hubbard,
and Petersen (1986), who use interaction terms to examine how
the relationship between industry price-cost margins and con-
centration changes over time.
18Consistent with this hypothesis, the 50 banks with the
highest CR3 values had the same rmmd.a in consecutive quar-
ters 24.2% of the time, while the 50 with the lowest CR3s had
the same rates in consecutive quarters only 14.8% of the time.
 THE PRICE-CONCENTRATION RELATIONSHIP IN BANKING
riod examined. Similar results are found for Su-
per-NOWs and shorter-term CDs. However, the
effect of concentration on longer-term CD rates is
marginal at best, reflecting the possibility that
these may be competed for on a broader basis
than local banking markets. We note, however,
that these price-concentration results do not rule
out the possibility that the efficient-structure hy-
pothesis also plays a role in the profit-concentra-
tion relationship.
As shown in the tables and text, these findings
are robust with respect to (i) the use of separate
OLS cross-section estimates in place of pooled
time series, cross section estimation, (ii) the choice
of concentration measure (CR3 or HERF), (iii)
the inclusion of firm-specificvariables of question-
able exogeneity (market share, bank branches, or
bank size), (iv) the treatment of concentration
under different state branching laws, and (v) the
inclusion of an aggregate interest rate in place of
the time dummies to control for time-series fac-
tors. Also examined, but not shown numerically,
are the effects of (i) the modeling of the dependent
variable as a market premium instead of a rate by
using the difference between the MMDA rate and
the Money Market Mutual Fund rate, (ii) the
inclusion of S & L data in the concentration mea-
sures, (iii) the use of additional variables to take
account of differences in state bank holding com-
pany laws, (iv) the use of squared concentration
terms, (v) the exclusion of the control variables
that do not have statistically significant coeffi-
cients, and (vi) the inclusion of banks with less
than 75% of their deposits in one market. In no
case are the market concentration results altered
qualitatively.
This study also investigates why the observed
effect of concentration on deposit rates varies so
greatly over the sample period. The difference in
deposit rates paid in concentrated and unconcen-
trated markets is found to be strongly related to
the aggregate level of interest rates.
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299
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