Market Power and Cost Efficiencies in Banking

Existing studies that quantify cost efficiencies in the banking industry do not account for local market power. If market power is ignored and increases with size, it gets counted as additional cost efficiencies which leads to an over-prediction. I address this limitation by developing a model of the demand for consumer deposits at the geographic market level and cost efficiencies at the firm level. Incorporating the network structure of banks in the analysis increases dimensionality of the bank’s choice set and also the possibility of multiple equilibria. To address these issues, I use moment inequality methods to estimate the cost parameters. Using a panel data from the U.S. banking industry, I find that the evidence of cost efficiencies is weak, at best, for all the banks. Using the estimated parameters, I simulate six mergers between banks of different sizes. In the short run, all the simulated mergers show dis-economies of scale on average. However, most of them show an increase in consumer welfare as the market power (or oligopoly) effect is dominated by an increase in the local branch density.