The Efficiency Cost of Market Power in the Banking Industry: A Test of the 'Quiet Life' and Related Hypotheses

Traditionally, concerns about market concentration have focused on mispricing and the restriction of output relative to competitive markets. This type of loss is typically measured by the standard welfare triangle. The associated welfare losses usually motivate antitrust policy. This paper focuses on another type of loss from concentration and market power that may be much larger. Firms that are not subject to rigorous market discipline may take some of their market power rewards not as higher profits, but as a "quiet life" in which cost efficiency suffers. Similarly, managers of firms in concentrated markets may exercise expense preference motives and worsen cost efficiency in this way. The question of whether increased concentration and market power reduces firm cost efficiency may be particularly important to policy analysis of the banking industry. The recent wave of mergers among large banking organizations, particular "horizontal" or "within-market" mergers between banking organizations situated in the same local markets raises concerns about the increase in local concentration. If the "quiet life" and related efficiency-reducing effects of concentration are substantial, they might be considered in the merger approval process along with the traditional concerns about the welfare loss due to mispricing and the safety and soundness of the consolidated enterprise. The authors estimate how bank efficiencies are affected by local market concentration, controlling for number of factors, including regions, state regulation, size, and corporate governance. The banks in the sample represent over two-thirds of all U.S. banking assets. The basic hypothesis tested is that the market power exercised by firms in concentrated markets provides a price "cushion" above the competitive level that allows firms to avoid the rigors of cost minimizing without necessarily exiting the industry. The authors' empirical application suggests that market concentration does result in significantly lower cost efficiency. Extrapolating the results to the entire U.S. banking industry, they find that the operating efficiency costs associated with market concentration appear to be several times larger than the social losses due to the noncompetitive pricing of bank outputs, as measured by the traditional "welfare triangle." The authors suggest that these results may have general implications regarding antitrust policy, and specific implications regarding regulation of the banking industry. If they hold up under further scrutiny, they suggest that antitrust and merger policy consider cost efficiency implications of impending mergers. Current Justice Department guidelines do not explicitly consider the possibility for laxity in cost controls that might be a results of increase in market power. The fact that banking mergers among banks in overlapping markets has not generally been found to improve cost efficiency could conceivably results from the efficiency costs of the higher concentration as measured here. That is, a reduction in market pressure to minimize costs may have offset the technical cost economies associated with the consolidations. These issues are important because so many regulatory issues involve changes in the degree of competition or market contestability.