Deregulation, the Internet, and the competitive viability of large banks and community banks

Deregulation, technological change, and increased competitive rivalry are transforming U.S. commercial banking from an industry dominated by thousands of small, locally focused banks into an industry where a handful of large banks could potentially span the nation and control the majority of its bank deposits. This paper examines the comparative strengths and weaknesses of large and small banks in this new environment, and outlines the strategic opportunities and threats that new technology - especially the Internet - pose for U.S. banks. We begin by documenting recent trends in bank size, industry structure, competitive conditions, and bank product mix. We argue that these trends are consistent with a simple competitive strategy framework in which commercial banks choose between two profitable business strategies: (a) a community bank business model in which banks have a local focus, a high cost structure, and sell low volumes of personalized service at high margins, and (b) a global bank business model in which banks have a national or international focus, a low cost structure, and sell high volumes of standardized financial products at low margins. Finally, we discuss how Internet banking is likely to affect this strategic equilibrium. In particular, we analyze how a shift away from brick and mortar branches and toward the Internet delivery channel will reduce the switching costs that currently dissuade retail deposit customers from changing banks. Based on the foregoing analysis, we conclude that the number of small banks will continue to decline in the future - not because the community bank business model is flawed, but because most of the small banks that use this model are poorly run. In the long-run, our analysis suggests that well-run community banks should be able to adapt their business practices to technological change and profitably co-exist with large, globally focussed banks.Banks and banking ; Financial institutions

Financial innovation, strategic real options and endogenous competition : theory and an application to Internet banking

Innovations in financial services continuously influence the scope of financial intermediation and the nature of competition between intermediaries. This paper examines the optimal exercise of strategic real options to invest in such an innovation, Internet banking technology, within a two-stage game, parameterized by the distribution of bank size and uncertainty over the profitability of investment, and empirically tests the results on a novel data set. Unlike traditional options, in which the distribution of the future value of the underlying asset is exogenous and the timing of exercise affects only the return to the option holder, the timing of the exercise of real options in a strategic context allows the option holder to manipulate the distribution of returns to all players. The value of the strategic investment option in our model, as a consequence, depends on both expected future profits as well as the variance of those profits. Expected profits to an entrant depend, in equilibrium, on its size, as measured by existing market share (concentration) or total assets, relative to its rivals. Conditional on the degree of uncertainty, larger banks should, as a consequence, exercise their options earlier than smaller banks, for purely strategic advantages, and act as market leaders in the provision of Internet banking services. Like ordinary options, however, the value of the strategic investment option to both large and small banks increases in uncertainty, implying that early exercise will be more likely the more information is available about potential demand. We test these hypotheses on investment in Internet banking services with data from a sample of 1,618 commercial banks in the tenth Federal Reserve District during 1999. Evidence indicates that relative bank size, as measured by either market share or asset size, positively influences the likelihood of entry into Internet banking, and trend-adjusted variation in income per person (a proxy for uncertainty of demand) negatively influences the likelihood of entry into Internet banking. In addition, market concentration of a bank's competitive rivals has a negative relationship with the likelihood of entering the market for Internet banking services. These relations are evident in both bivariate analysis and in multivariate logit regression analysis.Competition ; Internet ; Internet banking

The past, present, and probable future for community banks

We review how deregulation, technological advance, and increased competitive rivalry have affected the size and health of the U.S. community banking sector and the quality and availability of banking products and services. We then develop a simple theoretical framework for analyzing how these changes have affected the competitive viability of community banks. Empirical evidence presented in this paper is consistent with the model's prediction that regulatory and technological change has exposed community banks to intensified competition on the one hand, but on the other hand has left well-managed community banks with a potentially exploitable strategic position in the industry. We also offer an analysis of how the number and distribution of community banks may change in the future.Community banks

Learning by observing: information spillovers in the execution and valuation of commercial bank M&As

We hypothesize that banks become better able to manage acquisitions, and investors become better able to value those acquisitions, as these parties ‘learn-by-observing’ information that spills-over from previous bank M&As. We find evidence consistent with these hypotheses for 216 M&As of large, publicly traded U.S. commercial banks between 1987 and 1999. Our theory and our results are predicated on the idea that acquisitions of large and increasingly complex commercial banks were a relatively new phenomenon in the late-1980s, with no best practices to inform bank managers and little information upon which investors could base their valuations. Our findings provide a new explanation for why academic studies have found little evidence that bank mergers create value. Furthermore, our finding that investors become more accurate pricers of new phenomena as they observe greater quantities of those phenomena is consistent with the theory of semi-strong stock market efficiency.Bank mergers ; Financial institutions

Risk Management in an Age of Change

The environment in which banks and other financial services industry firms operate was once very stable. It is now increasingly permeated with change. Enhanced performance demands make this change salient to high-level decision-makers. Many of the opportunities firms now face are path-dependent and this will continue to be so. For firms to make effective choices in such an environment, both competitive strategy and the strategy-making process must come to terms with opportunities which evolve over time. Old decision-making systems and attitudes are unhelpful in this and may even be impediments to good outcomes. Risk inevitably features in getting these decisions right. All strategic decisions induce and impose constraints on the types of risk banks traditionally monitor and manage. This needs to be explicitly considered and is generally not. Strategic decisions also impose a new type of risk, detailed here, which also needs to be analyzed, monitored, and controlled. All these activities require changes, discussed in detail, both in decision-making protocols and in the organizational structures and routines supporting decision-making.

The determinants of success in the new financial services environment: now that firms can do everything, what should they do and why should regulators care?

Financial services industry ; Financial services industry - Europe ; Bank supervision ; Business forecasting

Safety, soundness, and the evolution of the U.S. banking industry

Although the banking system appears to be safer and sounder today than it was two decades ago, new risk challenges have arisen that could not have been anticipated in the 1980s. This article outlines the fundamental structural changes in the U.S. commercial banking industry since then. ; The author's strategic analysis of the current state of the industry compares the "transactions banking" business model practiced by large financial companies to the more traditional relationship-based banking business model. In particular, the author focuses on the different production technologies, product mixes, strategic behaviors, and risk-return trade-offs that characterize these two opposite approaches. In closing, the article discusses what these new developments may mean for the industry's ongoing safety and soundness.Banks and banking ; Bank supervision

Mergers and the changing landscape of commercial banking (Part II)

Bank mergers ; Financial institutions