Robert DeYoung

English

Research Papers in Economics

ESSAYS ON ISSUES THE FEDERAL RESERVE BANK FEBRUARY 2000
OF CHICAGO NUMBER 150
Chicago Fed Letter
1. National and local market structure
1980 ’82 ’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98
10
20
30
40
1,750
1,900
2,050
2,200
percent index
National deposit share
held by 10 largest banks
(left scale)
Average Herfindahl Index
in MSA markets
(right scale)
Note:  HHI = sum of squared market shares of all banks in market.
Source: Board of Governors of the Federal Reserve System.
Mergers and the changing
landscape of commercial
banking (Part II)
In a recent Chicago Fed Letter, I exam-
ined the motivations for, and the con-
sequences of, the tremendous wave of
U.S. bank mergers during the 1980s
and 1990s.1 In that document I reached
three main conclusions. First, I argued
there is little evidence of any systemat-
ic reduction in competition in retail
banking or small business financing
markets as a result of the bank merger
wave. Although the largest commercial
banks have a much more prominent
national position today than 20 years
ago, these banks’ shares of local banking
markets have not increased materially.
Second, I suggested that the current
bank merger wave is showing signs of
maturing. A number of commercial
banks have achieved nationwide or
near-nationwide geographic coverage,
and as additional banks attain this
geographic scope the demand for
large market extension mergers will
naturally diminish. Furthermore, the
rapid development of the Internet
and e-commerce may allow banks to
replace, or at least complement, their
merger-based growth strategies with
internal growth via electronic distribu-
tion of financial services. Since Part I
was written, the Financial Institutions
Modernization Act (FIMA) of 1999
abolished the historical separation
of commercial banking, investment
banking, and insurance underwriting.
This long-awaited development will
likely dampen the bank merger wave
further, as acquisitive banks shift their
focus—and their scarce acquisition
capital—away from purchasing other
banks and toward purchasing insurance
companies and securities firms.
Third, I indicated that from our van-
tage point at the end of the 1990s,
it may be too early to evaluate the
eventual competitive implications of
the bank merger wave. If fully success-
ful, the electronic delivery of retail
and wholesale banking services may
make the notion of “local” banking
markets obsolete. To the degree that
this happens—and to the degree
that large banks can limit the entry
and/or the mobility of small banks in
electronic markets—the increasing
national market shares of large com-
mercial banks may have more serious
competitive implications than is gen-
erally thought.
In this Fed Letter, I discuss the prospects
for small commercial banks in a post-
merger-wave banking industry in which
electronic delivery of financial services
becomes commonplace. In such a
world, should we expect “branchless”
delivery of financial services to be
dominated by a few large banks, or
will the advent of electronic banking
markets provide important strategic
opportunities for small banks? I pro-
pose a simple conceptual framework
for thinking about this question, a
framework that considers the strate-
gic advantages and disadvantages of
increased bank size.
Local versus national
banking markets
Between 1980 and 1998
the share of domestic de-
posits held by the nation’s
ten largest commercial
banks nearly doubled.
Large banks achieved
this growth primarily by
making market extension
mergers, which change
the ownership of the
acquired bank without
affecting the structure
of local banking markets.
As seen in figure 1 (which
is reprinted here from
Part I of this Fed Letter),
the national market
shares of large banks increased mark-
edly during the bank merger wave but
the concentration of local banking
markets remained stable. Hence, by
traditional measures of market struc-
ture, 20 years of bank mergers had lit-
tle adverse impact on competitive
conditions in U.S. commercial bank-
ing markets.
But these structural changes occurred
during the traditional “brick and mor-
tar” banking paradigm, in which most
retail banking and small business
banking services were provided by lo-
cal banks in local markets. Today, a
growing number of household and
business customers access account in-
formation, transfer funds, pay bills,
make trades, and apply for loans elec-
tronically, without ever setting foot in
a branch office. The banking industry
may be in the midst of a paradigm shift,
in which electronic delivery channels
and automated lending technology will
increasingly allow out-of-market banks
to compete for retail and small busi-
ness customers without establishing a
physical presence in the local market.
No one knows for sure how electronic
delivery channels will ultimately alter
the banking landscape, but somechanges seem fairly certain. An in-
creasing number of banks will begin
to offer financial services to retail and
small business customers nationally.
As this happens, local market concen-
tration will become a less relevant yard-
stick for assessing the competitive
impact of bank mergers. And bank
mergers themselves will become less
necessary for geographic expansion,
because electronic distribution will pro-
vide an alternative channel for growth.
Successfully managing this new tech-
nology may require existing bank
managers to develop new styles and
approaches. Some of the most acquis-
itive U.S. banks of the past decade
have recently experienced subpar
financial performance, due to unex-
pected difficulties absorbing the opera-
tions of the acquired banks, dissatisfied
target bank customers, and the chal-
lenges of managing a firm that sud-
denly doubles or triples in size or
complexity.2 These difficulties suggest
that the skills required to build large
banking empires are not necessarily the
same skills needed to operate those em-
pires successfully. Similar managerial
challenges could arise as banking com-
panies recently reshaped by geographic
transformation enter a new period of
technological transformation.
New technology and nationwide
banking markets
It seems certain that the Internet will
bring more banks, regardless of their
size or location, into closer competi-
tion with each other. Will large bank-
ing companies have an advantage in
this competition, or will the Internet
level the playing field by neutralizing
large banks’ existing distributional
advantage, i.e., their systems of multi-
ple branch and ATM locations?
The answer may depend on a decid-
edly low-tech strategic behavior not
generally included in the analysis of
banking markets: advertising. Although
establishing a physical presence on
the Internet is relatively inexpensive,
attracting customers to the web site
can be difficult. Potential customers
trying to decide among hundreds
of online banking options will find
themselves guided by brand images
developed with expensive advertising
campaigns. Not only do large banks
have deeper pockets than small banks,
a regional or national advertising
campaign is likely to resonate more for
a large bank than for a small bank—the
high visibility of large banks’ many
branch locations helps remind cus-
tomers of the advertising campaign
and increases the chance that they will
visit the Internet site. This potentially
potent combination of “click and mor-
tar” puts small banks at a clear market-
ing disadvantage.
These large bank marketing advantages
could be reinforced by the passage of
FIMA. In a world in which large, diver-
sified financial firms can cross-sell an
increasing array of financial products
to their customers, these firms could
be willing to spend more on advertis-
ing to attract a new customer than will
a more specialized bank. This may be
especially true for retail buyers of finan-
cial services, who have clear incentives
to shop for loans, bill paying, insurance
products, and asset management ser-
vices at a single site.
Despite these apparent marketing ad-
vantages, it is unlikely that the Internet
will allow large banks to dominate all
banking markets. Large banks often
tout economies of scale—cost savings
associated with large production vol-
ume—as an important factor motivat-
ing their growth. For example, credit
card lending and mortgage banking
are lines of business that exhibit scale
economies and as the banking industry
has consolidated an increasing portion
of these activities has become concen-
trated in a relatively small number of
large banks.3 Large financial services
firms tend to be well suited to highly
standardized, commodity-like activi-
ties like these that can be produced
and distributed in large volumes at
low unit costs, and the Internet tends
to be well suited to delivering highly
standardized financial products in
large volumes. For example, Allstate
insurance is phasing out its traditional,
relationship-based distribution channel
of insurance agents in favor of selling
its retail insurance products directly
over the Internet and through call
centers.4
However, some of the most desirable
banking customers are those willing
to pay high prices for customized finan-
cial products and services. Given the
impersonal nature of the technology,
the Internet may prove to be a poor
channel for delivering customized fi-
nancial services. For example, the
creditworthiness of many small busi-
nesses cannot be ascertained using
a “one-size-fits-all” underwriting ap-
proach like credit scoring, but only
by the close monitoring and relation-
ship-based practices provided by small,
local banks.5 Similarly, some private
banking customers may require high-
touch, personalized services that sim-
ply cannot be delivered via a nexus of
ATMs, call centers, and the Internet.
Although some large banks may prove
to be exceptions (e.g., the private
banking strategy of a Northern Trust
or the automated small business lend-
ing practice of a Wells Fargo), the fu-
ture profitability of small banks may
ultimately depend on how well they
exploit their natural advantages at serv-
ing relationship-based banking niches.
A framework for strategic analysis
Figure 2 presents a strategic map of the
banking industry.6 This map is a
greatly simplified depiction of the
strategic options available to banks,
based loosely on the above discussion.
Space near the bottom of the box
marks banking strategies that stress
larger scale and lower unit costs (as
opposed to strategies that stress small-
er size and higher unit costs, located
near the top of the box). Space near
the left side of the box marks banking
strategies that stress commodity-like
financial services that are not person-
alized or otherwise differentiated
from competitors’ products (as op-
posed to strategies that stress person-
alized financial services or financial
services differentiated by brand im-
age, located near the right side of the
box). The circles represent hypotheti-
cal banks, with the size of the circle
indicating bank size.
Hypothetical small and local banks
are located in the upper right corner.
These banks operate at low scale, incur
high unit costs, operate predominantly
through physical branch locations, and
sell relationship-based financial ser-
vices for which customers are willingMichael H. Moskow, President; William C. Hunter,
Senior Vice President and Director of Research;  Douglas
Evanoff, Vice President, financial studies; Charles
Evans, Vice President, macroeconomic policy research;
Daniel Sullivan, Vice President, microeconomic policy
research;  William Testa, Vice President, regional
programs and economics editor; Helen O’D. Koshy,
Editor.
Chicago Fed Letter is published monthly by the
Research Department of the Federal Reserve Bank
of Chicago.  The views expressed are the authors’
and are not necessarily those of the Federal
Reserve Bank of Chicago or the Federal Reserve
System. Articles may be reprinted if the source is
credited and the Research Department is
provided with copies of the reprints.
Chicago Fed Letter is available without charge from
the Public Information Center, Federal Reserve
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Chicago Fed Letter  and other Bank publications are
available on the World Wide Web at http://
www.frbchi.org.
ISSN 0895-0164
2. Strategic map of commercial banking
High
Costs
Low
High Low Differentiated products
s
?
Note: “Differentiated products” refers to the degree of personal
service, customized products, and/or brand image offered
by a bank.
to pay relatively high prices. Hypo-
thetical large regional or nationwide
banks are located in the lower left
corner. These banks operate at large
scale, incur low unit costs, operate
through a combination of physical
branches and the Internet, and offer
commodity-like products for which
customers are less willing to pay high
prices. In this example, the most prof-
itable strategy is to locate in the lower
right hand corner, operating at large
scale (which reduces unit costs) and
offering differentiated products (which
command high prices).
By definition, small banks cannot
migrate to this most profitable strate-
gy—unless they become large banks.
However, it might be possible for
large banks to implement this strate-
gy, depending on the skill with which
they can deploy personalized products
over electronic delivery channels.
Large banks currently customize finan-
cial services for some of their large
business clients (for example, M&A
financing); if large banks can custom-
ize financial services for retail and
small business customers on a large
scale basis—perhaps using electronic
delivery channels to reduce production
costs and make these services more
convenient—they will be able to take
away some of small banks’ most prof-
itable customers. The low-cost struc-
tures, wide product offerings, and
differentiated brand
images of large banks
would be difficult for
small banks to over-
come. However, if large
banks can only mass
produce commodity-
like products (such as
credit-scored small
business loans, stan-
dardized insurance
products, or automat-
ed asset management
without personalized
investment advice),
then relationship bank-
ing will continue to
provide a profitable
niche for small banks.
Conclusion
Just as the wave of do-
mestic bank mergers has produced
the first nationwide banks, the im-
plementation of new electronic deliv-
ery channels threatens to transform
the banking landscape once again.
This Fed Letter explores the prospects
for small commercial banks in a
post-merger-wave, post-Internet
banking industry. I argue that the fu-
ture success of small banks hinges on
their traditional advantages in rela-
tionship banking and personalized
financial services and on how these
advantages stack up against the com-
bination of low costs, convenient
one-stop shopping, and powerful
brand images that large banks may
be able to wield over electronic de-
livery channels.
As we consider how the Internet will
transform banking, it is important to
remember that this new delivery
channel is unlikely to change the
fundamental nature of the financial
products delivered over it. Consider
an example from e-commerce.
Amazon.com and its competitors
may be making the traditional book-
store obsolete, but they have not (yet)
made the printed book obsolete—
ironically, these Internet firms deliver
the books they sell not electronically,
but by surface mail. Whether e-bank-
ing leads to a substantial change in
the number and/or size of commer-
cial banks or just changes the way
1Robert DeYoung, 1999, “Mergers and the changing
landscape of commercial banking (Part I),” Chicago
Fed Letter, Federal Reserve Bank of Chicago, No. 145,
September.
2For a discussion of the post-merger experiences of
Bank One, First Union, and other ultra-acquisitive
banking companies, see Euromoney, 1999, “When
cutting cost is not enough,” November, pp. 58–60.
3By mid-1999, the top ten credit card issuers in the
U.S. held more than a 75% market share (see Chica-
go Tribune, 1999, “Cards getting less credit for bank
industry growth,” August 27). For evidence on scale
economies and growing concentration mortgage
banking, see Clifford V. Rossi, 1998, “Mortgage
banking cost structure: Resolving an enigma,”
Journal of Economics and Business, Vol. 50, No. 2.
pp. 219–234, and Mitchell Stengel, 1995, “From
traditional mortgage lending to modern mortgage
banking,” Office of the Comptroller of the Currency,
Quarterly Journal, No. 4, pp. 11–18.
4See Chicago Tribune, 1999, “Allstate points to new
future,” November 11.
5See Loretta J. Mester, 1999, “Banking industry con-
solidation: What’s a small business to do?” Federal
Reserve Bank of Philadelphia, Business Review, Janu-
ary/February, pp. 3–16.
6For an introduction to strategic maps, see Michael
E. Porter, 1980, Competitive Strategy, New York: Free
Press.
that existing banks deliver financial
services to their customers remains for
now an open question.
—Robert DeYoung
Senior economist and economic advisorP
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The CFMMI rose 0.3% from October 1999 to November 1999. In comparison,
the Federal Reserve Board’s IP for manufacturing increased 0.5% in November,
after increasing 0.8 in October.
Light truck production decreased from 7.1 million units in November to 6.9
million units in December and car production declined from 5.9 million units
to 5.6 million from November to December.
The Midwest purchasing managers’ composite index (a weighted average of
the Chicago, Detroit, and Milwaukee surveys) for production decreased to
57.0% in December from 61.6% in November. The purchasing managers’ in-
dex decreased in all three surveys. The national purchasing managers’ survey
for production increased from 57.4% to 58.7% from November to December.
Sources: The Chicago Fed Midwest Manufactur-
ing Index (CFMMI) is a composite index of 16
industries, based on monthly hours worked and
kilowatt hours. IP represents the Federal Reserve
Board’s Industrial Production Index for the U.S.
manufacturing sector. Autos and light trucks are
measured in annualized units, using seasonal ad-
justments developed by the Board. The purchas-
ing managers’ survey data for the Midwest are
weighted averages of the seasonally adjusted pro-
duction components from the Chicago, Detroit,
and Milwaukee Purchasing Managers’ Association
surveys, with assistance from Kingsbury Interna-
tional, LTD., Comerica, and the University of
Wisconsin–Milwaukee.
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Manufacturing output indexes, 1992=100
Purchasing managers’ surveys:
net % reporting production growth
Dec. Month  ago Year ago
MW 57.0 61.6 54.4
U.S. 58.7 57.4 46.8
Motor vehicle production
(millions, seasonally adj. annual rate)
Dec. Month  ago Year ago
Cars 5.6 5.9 5.8
Light trucks 6.9 7.1 6.5
IP
CFMMI
Manufacturing output indexes
(1992=100)
Nov. Month  ago Year ago
CFMMI 136.4 136.0 131.2
IP 144.7 144.0 138.3
1996 1997 1998 1999
110
122
134
146
Tracking Midwest manufacturing activity

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

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

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