Preliminary. The views may not be shared by others in the Federal Reserve System.
The structure-conduct-performance (S-C-P) paradigm has been one of the most tested hypotheses in the industrial organization literature. It proposes that market concentration lowers the cost of collusion between firms, protects market incumbents from competition, and results in higher firm profits and inferior prices for consumers. The validity of the paradigm, the basis for antitrust policy, has been supported in numerous studies.
The idea behind the paradigm seems straightforward. Incumbent firms in a market are concerned about how competitors will respond if other incumbents change prices. That is, they are concerned about the response functions of competitors. Price increases will be tempered if incumbents believe their potential price increase will not be matched by other market participants while price decreases will be.
Again, the arguments behind the paradigm are logical if the assumptions underlying it hold true. Most importantly, the initial step in competitive analysis (deciding the potential competitive impact of a merger of incumbents) is to define the market; both for the products produced and the geographic location. In banking, the industry we analyze, it has been common for researchers to alter the array of competitors. Based on the Supreme Court ruling in the Philadelphia National Bank case, regulators consider banking markets to be local when evaluating the potential impact of mergers on market competition and bank safety. This drives the procedures currently used by financial regulators and the Justice Department for bank merger analysis.
Our theory is that the assumption of banking markets being local is suspect. With the proliferation of nationwide branching and internet banking in recent years, it is highly likely that banks pay less attention to local market conditions. Rather they likely take a much larger, perhaps national perspective. If a multiple market bank does not base its pricing decision on local market conditions, then their competitive response to other banks in the local market may be muted.
We empirically evaluate the validity of the assumption that banking markets in the U.S. are local and evaluate the impact on the traditional paradigm. We find evidence consistent with pricing decisions not being determined locally. We also attempt to account for this non-local behavior and determine its impact on the use of the SCP paradigm in banking.