Banking Theory and Regulation

The Industrial Organization of Banking

Rafael Repullo
CEMFI, Madrid, Spain
FM403 Management and Regulation of Risk
2 November 2015

Introduction
Banks as intermediaries that take deposits and give loans
Banks face
Supply of deposits that depends on the deposit rate
Demand for loans that depend on the loan rate
Focus on determination of equilibrium deposit and loan rates
For different market structures (competition to monopoly)
Effect of having an interbank market
Effect of regulations such as reserve or capital requirements

Outline
Model of perfect competition
Reserve and capital requirements
Intermediation costs
Model of (local) monopoly banks
Model of Cournot competition
Model of Bertrand competition
Model of monopolistic competition (circular road)

Part 1
Perfect competition

Model setup (i)

Large number of banks that compete for deposits and loans
Banks take as given deposit rate rD and loan rate rL
Market supply of deposits D(rD), with D(rD) > 0
Market demand for loans L(rL), with L(rL) < 0
Interbank market where banks can borrow or lend at rate r
Monetary policy rate set by central bank

Model setup (ii)

Assumptions:
1. Bank loans are riskless
2. Banks have no equity capital
3. There are no intermediation costs

Banks balance sheet and profits

Balance sheet of an individual bank
l=d+b
where l denotes the amount of loans, d the amount of deposits,
and b the amount of interbank borrowing (lending if b < 0)
Banks profits
= lrL drD br
where lrL are the revenues from lending, drD the costs of deposit
funding, and br the costs of interbank borrowing

Rewriting banks profits

Substituting b = l d into the expression for gives
= lrL drD (l d)r = l(rL r) + d(r rD)
Banks profits can be decomposed into two terms
Profits from lending: l(rL r)
Profits from deposit taking: d(r rD)

Competitive equilibrium
Competitive equilibrium characterized by zero-profit conditions
rL = r and rD = r
Why rL = r? Profits from lending: l(rL r)
If rL < r no bank would want to lend
If rL > r banks would like to lend infinitely large amounts
Why rD = r? Profits from deposit taking: d(r rD)
If rD > r no bank would want to take deposits
If rD < r banks would like to take infinite deposits

Equilibrium quantities of deposits and loans

Equilibrium deposits D(rD) = D(r)
Equilibrium loans L(rL) = L(r)
What happens when L(r) > D(r)?
Banks would be net borrowers in interbank market
Central bank has to lend L(r) D(r) > 0 to banks
What happens when L(r) < D(r)?
Banks would be net lenders in interbank market
Central bank has to borrow D(r) L(r) from banks
(by issuing debt certificates or by remunerating reserves)

The case of a structural liquidity deficit

r

r1

D(r )

CB lending


L(r1 )
D(r1 )

L( r )

The case of a structural liquidity surplus

r

r2

D(r )

CB borrowing



L(r2 )
D(r2 )

L( r )

Separability of lending and deposit taking

Given the policy rate r
Loan quantities and loan rates only depend on L(rL)
Deposit quantities and deposit rates only depend on D(rD)
Some banks could specialize in lending
Using interbank market to borrow required funds
Some banks could specialize in deposit taking
Using interbank market to place surplus funds

Part 2a
Reserve requirements

A non-remunerated reserve requirement

Suppose that banks are required to invest fraction of deposits
in a non-remunerated account at central bank
If interbank rate r > 0 there will be no excess reserves Why?
Balance sheet of an individual bank
l + d = d + b
where d are the banks reserves , which implies
b = l (1 )d

Banks profits with the reserve requirement

Since reserves are non-remunerated, banks profits are the same
= lrL drD br
Substituting b = l (1 )d into this expression gives
= lrL drD [l (1 )d]r = l(rL r) + d[(1 )r rD]

Competitive equilibrium
Competitive equilibrium characterized by zero-profit conditions
rL = r and rD = (1 )r
Given interbank rate r
No change in loan rate rL or in loan quantities
Deposit rate rD is now a fraction 1 of interbank rate r
Reduction in the amount of deposits

Implications for the central bank

In case of a structural liquidity deficit
Deficit will increase by D(r) D((1 )r )
In case of structural liquidity surplus
Surplus will decrease by D(r) D((1 )r )

The case of a structural liquidity deficit

D((1 )r )

r1

D(r )

CB lending




L(r1 )
D ((1 )r1 )

L( r )

The case of a structural liquidity surplus

D((1 )r )

r2

D(r )

CB
borrowing



L(r2 )
D(r2 )
D((1 )r2 )

L( r )

Part 2b
Capital requirements

Introducing bank capital

Suppose that banks are allowed to raise equity capital
Balance sheet of an individual bank
l=d+b+k
where k denotes the banks capital
Suppose that shareholders require return on their capital
If > r banks will have no capital Why?

Introducing a capital requirement

Suppose banks are required to fund a fraction of their loans
with capital (interbank lending is not subject to the requirement)
If > r the capital requirement will be binding Why?
Balance sheet of an individual bank
l = d + b + l
where l is the banks capital, which implies
b = (1 )l d

Banks profits with the capital requirement

Banks profits
= lrL drD br l
Substituting b = (1 )l d into this expression gives
= lrL drD [(1 )l d]r l
= l[rL ( + (1 )r)] + d(r rD)

Competitive equilibrium
Competitive equilibrium characterized by zero-profit conditions
rL = + (1 )r and rD = r
Given interbank rate r
No change in deposit rate rD or in deposit quantities
Loan rate rL is now weighted average of interbank rate r
(with weight 1 ) and cost of capital (with weight )
Reduction in the amount of loans

Implications for the central bank

In case of a structural liquidity deficit
Deficit will decrease by L(r) L( + (1 )r)
In case of structural liquidity surplus
Surplus will increase by L(r) L( + (1 )r)

The case of a structural liquidity deficit

r

r1

L( + (1 )r )

D(r )

CB
lending



D(r1 )

L( r )
L( + (1 )r1 )

The case of a structural liquidity surplus

r

r2

L( + (1 )r )

D(r )

CB borrowing




D(r2 )
L( + (1 )r1 )

L( r )

Part 2c
Intermediation costs

Introducing intermediation costs

Suppose that each bank is characterized by a cost function c(d,l)
that is increasing (a reasonable assumption) and convex (to get
interior solutions) in the amounts of deposits d and loans l
Banks profits
= lrL drD br c(d,l)
Substituting b = l d from balance sheet gives
= lrL drD (l d)r c(d,l)= l(rL r) + d(r rD) c(d,l)

Bank behavior
Since banks objective function is concave, its behavior is
characterized by first-order conditions

c(d , l )
c(d , l )
rL r =
and r rD =
l
d
Notice that in this model
1. Intermediation margins are positive (to cover costs)
2. Lending and deposit taking are not separable unless

2 c(d , l )
=0
d l

Competitive equilibrium
Solution to the first-order conditions gives
Individual loan supply function l(rL, rD, r)
Individual deposit demand function d(rD, rL, r)
Given the policy rate r, equilibrium loan and deposit rates
are obtained by solving

nl (rL , rD , r ) = L(rL ) and nd (rD , rL , r ) = D(rD )

where n is the number of (identical) banks in the market

Part 3
Local monopoly banks

Local monopoly banks

Suppose that each bank in this economy is a local monopolist
characterized by
Local supply of deposits D(rD), with D(rD) > 0
Local demand for loans L(rL), with L(rL) < 0
There is an economy-wide interbank market where banks can
borrow or lend at rate r

Bank behavior (i)

The banks problem is

max [ L(rL )(rL r ) + D(rD )(r rD )]

( rL , rD )

Assuming concavity, its behavior is characterized by

first-order conditions

(rL r ) L(rL ) + L(rL ) = 0 and (r rD ) D(rD ) D (rD ) = 0

Bank behavior (ii)

The first-order conditions may be written as

rL r 1
r rD
1
=
=
and
rL
rD
L
D
where L is the elasticity of the local demand for loans
and D is the elasticity of the local supply of deposits
Notice that in this model
1. Banks will be making positive profits (when L , D > 0 )
2. When L , D we converge to perfect competition
rL = r and rD = r

Part 4
Cournot competition

Cournot competition
Suppose that there are n 2 identical banks that compete la
Cournot (i.e., they use quantities as their strategic variables)
Interbank market where banks can borrow or lend at rate r
In Cournot models it is convenient to work with
Inverse supply of deposits rD (D)
Inverse demand for loans rL (L)

Inverse demand for loans

rL ( L)

rL

L(rL )

L(rL )

Bank behavior (i)

The problem of bank j is

max l j ( rL (l j + i j li ) r ) + d j ( r rD (d j + i j di ) )
( d j ,l j )

Loans of
bank j

Loans of
other banks

Deposits
of bank j

Deposits of
other banks

Note that banks are playing a game

rL depends on js decision and that of the other n 1 banks
rD depends on js decision and that of the other n 1 banks

Bank behavior (ii)

Assuming concavity, optimal behavior is characterized by
first-order conditions

rL ( L) r + l j rL ( L) = 0 and r rD ( D) d j rD ( D ) = 0
where L = in=1li and D = in=1di

Cournot equilibrium
Setting lj = L/n and dj = D/n in first-order conditions gives
conditions that characterize symmetric Cournot equilibrium

n [ rL ( L) r ] + LrL ( L) = 0 and n [ r rD ( D) ] DrD ( D ) = 0

These conditions may be written as

rL r
r rD
1
1
=
=
and
rL
n L
rD
n D
Notice that when n we converge to perfect competition
rL = r and rD = r

Special case
When deposit supply and loan demand functions are isoelastic

D(rD ) = rD D and L(rL ) = rL L

we can solve for Cournot equilibrium rates

1
r
1
 1 +
 1
rL =
r and rD =

1
1

n D
L
1
1+
n L
n D
r

rL equals the interbank rate r multiplied by mark-up

rD equals the interbank rate r multiplied by mark-down

Discussion (i)
Use of quantities as strategic variables does not appear realistic
Prices seem to provide better approximation to real world
However, Cournot equilibrium could be obtained as outcome of
a two-stage game (Kreps and Scheinkman, 1983)
First stage: Banks choose capacity (branches, etc.)
Second stage: Banks compete in prices

Discussion (ii)
Problem with price competition in the case of banks
Two-sided competition for deposits and loans
When banks simultaneously choose deposit and loan rates
Balance sheet constraint lj = dj may not be satisfied
Game played by banks is not well defined
Problem is solved when there is competitive interbank market
Separation of lending and deposit taking
Alternatively, focus on competition for either deposits or loans

Part 5
Bertrand competition

Bertrand competition
Suppose that there are n 2 identical banks that compete la
Bertrand (i.e., they use prices as their strategic variables)
Interbank market where banks can borrow or lend at rate r
In Bertrand models it is convenient to work with
Supply of deposits D(rD)
Demand for loans L(rL)
where rD is the highest deposit rate and rL is the lowest loan rate
in the market

Bertrand equilibrium
The symmetric Bertrand equilibrium is characterized by
zero profit conditions
rL = r and rD = r
Proof in four steps
Cannot have rL < r
Cannot have rL > r
Cannot have rD > r
Cannot have rD < r

Bertrand paradox
It is hard to believe that firms in industries with few firms never
succeed in manipulating the market price to make profits.
Jean Tirole (1988)
How can the Bertrand paradox be avoided?
Relax assumption that deposits (or loans) of the different
banks are perfect substitutes
Bertrand competition with differentiated products

Part 6
Monopolistic competition

The circular road model

Model of competition in deposit market in which banks invest
in asset that pays an exogenous return r
There are n 2 banks located on circumference of unit length
Continuum of depositors distributed uniformly in circumference
Each depositor has unit wealth that wants to deposit in bank
Travelling to bank involves travel cost per unit of distance

The case n = 4
Bank 1

Bank 4

Bank 2

Bank 3

The case n = 4
Bank 1

Depositor i

Bank 4

Distance i Cost i

Bank 3

Bank 2

Symmetric Nash equilibrium (i)

Deposits of bank j when if offers rDj and the other banks offer rD
Bank j has two effective competitors, banks j 1 and j + 1
Depositor at distance from bank j (and distance 1/n from
bank j 1) will be indifferent between the two banks if

rDj = rD
n

Solving for in this equation gives

1 rDj rD
(rDj , rD ) = +
2n
2

The case n = 4
Bank j 1

Distance

1
to bank j 1
n
Marginal depositor

Distance to bank j

Bank j + 1

Bank j

Symmetric Nash equilibrium (ii)

Taking into account symmetric market area between j and j + 1
Supply of deposits of bank j

1 rDj rD
d (rDj , rD ) = 2 (rDj , rD ) = +
n

Notice that
1. d (rDj , rD ) is increasing in rDj and decreasing in rD
2. d (rDj , rD ) = 1/ n for rDj = rD equal sharing of depositors

Symmetric Nash equilibrium (iii)

The problem of bank j is

1 rDj rD
max d (rDj , rD )(r rDj ) = +
rDj

(r rDj )

The first-order condition is

r rDj

1 rDj rD

=0

Setting rDj = rD (symmetric equilibrium) gives deposit rate

rD = r

Properties of equilibrium
Intermediation margin

r rD =

Increasing in travel cost (greater market power)

Decreasing in number of banks n (greater competition)
When /n 0 we converge to perfect competition rD = r
Equilibrium bank profits

(n) = (r rD ) = 2
n
n

Equilibrium with free entry

Assume that banks can freely enter the market at a fixed cost F
Number of banks n in a free entry equilibrium

(n ) = F n =

F
Increasing in travel cost (greater market power)
Decreasing in fixed cost of entry F

Optimal number of banks (i)

Social welfare

W (n) = r nF 2n

1/2n

x dx

Three terms
1. Return of banks unit investment = r
2. Banks entry costs = nF
3. Depositors travel costs = 2n

1/2n

x dx =

4n

Optimal number of banks (ii)

Socially optimal number of banks

1 n
n = arg max n W (n) =
=
2 F 2
*

Excess entry in the free entry equilibrium

Twice as many banks as in the optimum
Rationale for restrictions in entry (or in branches)

References
Freixas, X., and J.-C. Rochet (1997), Microeconomics of Banking, MIT
Press, Chapter 3.
Chiappori, P.-A., D. Perez-Castrillo, and T. Verdier (1995), Spatial
Competition in the Banking System: Localization, Cross Subsidies, and the
Regulation of Deposit Rates, European Economic Review, 39, 889-918.
Klein, M. (1989), Theory of the Banking Firm, Journal of Money, Credit
and Banking, 3, 205-218.
Kreps, D., and J. Scheinkman (1983), Quantity Precommitment and
Bertrand Competition Yield Cournot Outcomes, Bell Journal of Economics,
14, 326-337.
Salop, S. C., (1979), Monopolistic Competition with Outside Goods, Bell
Journal of Economics, 10, 141-156.
Tirole, J. (1988), The Theory of Industrial Organization, MIT Press, Chapters
5 and 7.