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Competition among banks: Good or bad?
Nicola Cetorelli

Introduction and summary
In recent years we have witnessed a substantial convergence of research interest and the opening of a debate on the economic role of market competition in the banking industry. The need for such a debate may

seem unjustified at first. The common wisdom would
hold that restraining competitive forces should unequivocally produce welfare losses. Banks with monopoly power would exercise their ability to extract rents by
charging higher loan interest rates to businesses and
by paying a lower rate of return to depositors. Higher
lending rates would distort entrepreneurial incentives
toward the undertaking of excessively risky projects,
thus weakening the stability of credit markets and
increasing the likelihood of systemic failure. Higher
lending rates would also limit firms’ investment in
research and development, thus slowing down the
pace of technological innovation and productivity
growth. Lower supply of loanable funds, associated
with higher lending rates, should also be reflected in
a slower process of capital accumulation and, therefore, in a lack of convergence to the highest levels of income per capita.
These are some of the conventional effects that
market power in the banking industry is commonly
thought to generate. However, in more recent years,
researchers have begun analyzing additional issues
in the matter of bank competition, highlighting potentially negative aspects and so raising doubts regarding the overall beneficial welfare impact of bank competition on the economy. The research effort devoted to this issue has picked up noticeably, a sign that the

time is ripe for an open debate regarding the costs
and benefits of bank competition.1
The policy implications associated with this issue, related to the regulation of the market structure of the banking industry, are especially relevant. In
fact, banking market structure is a traditional policy

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variable for the regulator. Implicitly or explicitly motivated by the desire to restrain banks’ ability to extract rents, policymakers would typically recommend measures aimed at fueling competition, promoting

the liberalization of financial markets and removing
barriers to entry (see, for example, Vittas, 1992). In
light of the most recent regulatory changes affecting
the U.S. financial industry, the policy relevance for
U.S. regulators is more current than ever. In 1992 intrastate branching restrictions were relaxed, followed in 1994 by the passage of the Riegle–Neal Interstate
Banking and Branching Efficiency Act, which allows
bank holding companies to acquire banks in any state
and, as of June 1, 1997, to branch across state lines.
Finally, 1999 saw the passage of the Financial Services Modernization (Gramm–Leach–Bliley) Act, allowing the operation of commercial banking, investment banking, and insurance underwriting
within the same holding company. Such regulatory
changes continue to have a significant impact on the
market structure of the banking industry and on
banks’ competitive conduct. A deeper analysis of the
economic role of bank competition should thus contribute to our understanding of the role of the regulator and the consequences of regulatory action and, therefore, support more effective policymaking.

The goal of this article is to summarize some of
the arguments that have recently emerged and to suggest some new lines of investigation. In the next section, I describe theoretical contributions that have identified both positive and negative effects of bank

competition. Subsequently, I illustrate the results of

Nicola Cetorelli is an economist at the Federal Reserve
Bank of Chicago. The author thanks David Marshall
for his useful comments.

2Q/2001, Economic Perspectives

existing empirical studies, which present mixed evidence regarding the economic role of bank competition. The main conclusion that seems to...
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