Assistant Professor Tjomme Rusticus Weighs the Benefits of Competition for the Banking Industry

Most economists assume that competition is good for consumers. Yet, because of the important role of banks in our monetary system, economists are also very interested in the impact of competition on the banks themselves.

The financial crisis of 2008-2009 provided a perfect opportunity for Assistant Professor Tjomme Rusticus to test the connection between bank competition and financial stability, as well as its impact on the crisis itself.

“We looked into the financial crisis as the setting for our study,” Rusticus says.  “It was severe enough that we could actually get a sizable sample of bank failures. In a normal year there might be a few small banks that go under, but not a large enough sample to do statistical tests.”

According to the data, competition is beneficial

With this data at their disposal, the researchers concluded that competition is good for stability. That runs counter to traditional economic theories that posit that less competition helps boost profits that solidify banks’ finances, which in turn is good for their ability to weather the storms. However, it is consistent with newer theories that take into account the behavior of borrowers, such as the work by Carlson professor John Boyd and others.

“Based on our findings it looks like it’s important to have a competitive banking market,” Rusticus says. “We already know that for consumers in other businesses; that’s one of the reasons we have antitrust laws. But for the stability of the banking system itself, it is also not good to just have a few big banks.”

The study compared banks within the U.S., gathering data on the number and market share of banks within each state and how those banks fared during the financial crisis while making statistical adjustments for banks that do business in multiple states.

Lower profits, but less likely to fail

The research found that banks facing more competition earned lower interest margins, the difference between the interest banks charge on loans and what they pay on deposits. They also had lower profitability before the crisis. This is consistent with competition forcing banks to offer customers a better deal which lowers their profit.

However, banks facing greater competition made investments with lower risks, and they actually did better during the crisis. In particular, they were less likely to be targeted for regulatory intervention and less likely to fail during the financial crisis.

Beyond exploring the relationship of competition to bank failures, Rusticus and his co-authors tracked how competition had an impact on mortgage applications before the crisis and real estate prices before and during the financial crisis.

“The boom and bust in housing prices was worse in states with lower banking competition and the loan rejection rates were higher if there was more competition,” Rusticus says. “Banks were stricter where there was more competition.”

Banks with less competition took more risks in the mortgage market, which led to more credit and inflated real estate prices, and subsequently greater declines in real estate prices.

“More competition makes the banks a little more diligent in who they give the mortgage to, which drives up the housing prices less and then results in a smaller crash,” Rusticus says.