The New Bank-Thrift Competition:Will It Affect Bank Acquisitionand Merger Analysis?MICHAEL E. TREBING

HE Depository Institutions Deregulation andMonetary Control Act (MCA) enacted by Congressin March 1930 will significantly affect the competitiveenvironment in which financial institutions operate.This act broadens both the asset and liability powersof savings and loan associations (S&Ls), mutual sav-ings banks and credit unions, opening opportunities forthese institutions that traditionally have been limitedto banks. In light of these new powers and the in-creasing erosion of both legal and economic differ-ences between thrift institutions and banking organi-zations, thrifts have become important competitors inmarkets for banking services — especially for trans-action or checking accounts.1 Logically, the presenceof thrift institutions should carry greater weight inanalysis of mergers between commercial banks andacquisitions of banks by bank holding companies(BHCs).

The following discussion reviews several provisionsof the MCA that permit more intense bank-thrift com-petition, describes the current approach used by bank-ing regulatory agencies to review applications forapproval of bank mergers and BHC acquisitions,and discusses its validity in light of the new legisla-tion. Finally, the article discusses some alternativeapproaches to the analysis of competition in localmarkets.

THE MCA PROVISIONSThe distinctions between thrifts and banks have be-

come less rigid because of a long list of recent finan-

tThe term “thrift institutions” ia this article is defined as say-ings and loan associations, credit unions and mutual savingsbanks.

cial innovations and the geographic expansion of so-called “non-banking” institutions.2 The MCA, in re-sponse to these developments, reduces even furtherthe actual differences between banks and thrifts, Regu-lations that have attempted to control or constrainpricing and portfolio decisions of financial institutionsare being liberalized, In essence, the act provides fora greater reliance on market forces to determine boththe flow of deposits to financial institutions and theflow of credit from these institutions to borrowers. Themajor elements of the MCA that will affect bank-thrift competition are listed in table 1.~

An important change is the authorization of interest-earning “transaction” accounts at both banks andthrifts. This is achieved through the nationwide legali-zation of negotiable order of withdrawal (NOW)accounts, automatic transfer service (ATS) accountsand credit union share drafts.4 In some areas of thecountry (especially New England), depository in-

2See Jean M.. Lovati, “The Growing Similarity Among FinancialInstitutions,” this Review (October 1977), pp. 2-11, andHarold C. Nathan, “Nonhank Organizations and the McFad-den Act,” Journal of Bank Research (Summer 1980), pp.80-86.

3For a more detailed discussion of the elements of the MCAsee “The Depository Institutions Deregulation and ~clonetaryControl Act of 1980,” Federal Reserve Bulletin (June 1980),pp. 444-53.

~ATS and NOW accounts represent a type of individual “check-ing” account. By providing for the automatic transfer of fundsfrom a savings account to cover checks drawn against a zero-balance ATS account, individuals can earn interest on “check-ing” balances. NOW accounts are interest-eaming savingsaccounts against which customers call write “negotiabledrafts.” Similarly, credit union share drafts permit payabledrafts drawn on a credit union member’s interest-earningshare account. Share drafts, which resemble checks, are proc-essed through the credit union’s account at a commercialbank.

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Table 1Selected Provisions from the DepositoryInstitutions Deregulation and MonetaryControl Act of 1980

1. The phase-out of interest rate ceilings on deposits overa six-year period

2. The authorization to ofler NOW (negotiable order olwithdrawaI~ accounts (fundamentally. interest-earningchecking accounts~at all federally insured depository,nstilulions beginning December 31, 1980 to individualsand rion-profi: organizations

3. The authorization o~share drafts at federally insuredcredit unions (effective March 31, 1980)

4. The authorizalior for mutual savings banks to o’ferdemand deposi1s to business customers

5. Increased investment oplons for thrift insttulionsFor federal-chartered savings and loans:

a. consumer lending commercial paper, anddebt security investment of up to 20 per-cent of assels

b. issuance of credit cardsc. trust-fiduciary powers

For federal:y insured credit unions:a. real eslaie loans

For federal mulual savings banks.a. commercial, corporate and business loans.

(up to 5 percent of assets)

stitutions had already offered interest-earning trans-action accounts since the early l970s. Accompanyingthese powers is the provision for the gradual phase-out of deposit interest rate ceilings.

In addition to these significant changes, the MCAallows S&Ls to engage in consumer lending, trustactivities and credit card operations. The MCA au-thorizes thrifts to invest in, sell, or hold commercialpaper and corporate debt securities (up to 20 percentof assets). Limited business and commercial loanpowers have also been granted to federally charteredmutual savings banks.

The basic findings of the act are that the existinginstitutional structure has discouraged persons fromsaving, created inequities for depositors, impeded theability of depository institutions to compete for fundsand failed to achieve an even flow of funds amonginstitutions. The act also states that all depositors areentitled to receive a market rate of return on theirsavings.

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Credit market activity of thrifts over the pastdecade has developed by piecemeal expansion; theseinstitutions evolved originally as special-purpose in-stitutions whose asset-liability powers have been ex-tended only by gaining legislative approval.5 Legisla-tion in the 1970s has increasingly widened theirpowers and scope of business. The new powers legal-ized in the MGA will affect further the traditionallines of business that have separated these institutions;banks and thrifts will now compete more directly formany lines of business.

CURRENT METHOD OF ANALYZING

COMPETITIONThe Bank Holding Company Act of 1956 requires

the Federal Reserve to consider the likely effects ofproposed holding company formations and acquisitionson competition, the convenience and needs of thecommunities involved, and the financial and mana-gerial resources and future prospects of the institu-lions involved.6 If the Board of Governors finds thata transaction will substantially lessen competition (ortend to create a monopoly or be in restraint of trade),the Board must deny the application unless the anti-competitive effects are judged to be clearly outweighedby “the convenience and needs of the community.”

Legal DoctrineThe critical problem in antitrust law is selecting

the specific industry and industry output (or ‘<line ofcommerce”) to use in analyzing competition betweenfirms. In analyzing cases under the Bank HoldingCompany Act, the Federal Reserve has generallychosen “commercial banking” to be the relevant lineof commerce. This definition is based on the SupremeCourt’s controversial Philadelphia National Bank de-cision in 1963.~

In this case, the Court concluded that commercialbanks have an advantage over other financial institu-tions in attracting funds for loans and other services

FEDERAL RESERVE BANK OF ST. LOUIS

5See Leonard Lapidus, “Commercial Banks and Thrift Institu-tions: The Differing Portfolio Powers,” Banking Law •fournol(May 1975), pp. 450-93, and Jean M, Lovati, “The Chang-ing Competition Between Commercial Banks and Thrift Insti-tutions for Deposits,” this Review (July 1975), pp. 2-8.

°Competitive analysis is also done with respect to applicationsfiled under the Change in Bank Control Act of 19,8 andmergers filed under the Bank Merger Act of 1960.

~United States v. Philadelphia National Bank, 374 U.S. 321(1963). Subsequent Supreme Court cases have upheld thisdecision. See United States v. Phillipshurg National Bank andTrust Co., 399 U.S. 350 (1970); and United States v. Con-necticut National Bank, 418 U.S. 655 (1974).

FEDERAL RESERVE BANK OF ST. LOUIS FEBRUARY 1981

since only they can legally accept demand deposits.In addition, banks were said to enjoy “settled con-sumer preferences” for full-service banking. Thus, the“general store” nature of the banking business madeit a distinct line of commerce, distinguishing banksfrom other financial institutions.

Banking agencies have relied on simple marketshare tests to judge the likely effects of mergers orBHC acquisitions on competition, using “concentra-tion ratios” as a form of prima facie evidence of theseeffects on competition. A concentration ratio is a sum-mary measure intended to represent the degree ofmarket power that larger firms possess.8 This ratio isdefined as the percentage of total industry activity(measured by output, employment, assets, etc.) ac-counted for by the larger firms. A four-firm concen-tration ratio (using total deposits as a proxy foroutput) for all the commercial banks in a local bank-ing market, for example, may be 75 percent; that is,the four largest banks hold 75 percent of the totalbank deposits in this market.°

Although other factors are analyzed in evaluatingthe competitive effects of mergers and acquisitions,concentration ratios continue to be the main factors insuch analysis.’°The important issue is that the calcu-lation of concentration ratios using commercial bankorganization deposit data alone accepts the Court’s

5For a discussion of concentration measures used in analysisof banking markets, see “Measures of Banking Structure andCompetition,” Federal Reserve Bulletin (Septeniher 1965),pp. 1212-22.

‘See the appendix for a discussion of how the relevant geo-

graphic market is defined.10

This point is highlighted by the merger guidelines publishedby the Justice Department in 1968 which are frequentlycited in bank merger and acquisition analysis. These guide-lines indicate that the department will challenge a hori-zontal merger between firms in a concentrated industry (i.e.,one with a four-firm concentration ratio greater than 75~)when the following market shares are involved:

Acquiring AcquiredFirm Firm4% 4% or more

10% 2% or15% 1% or more

In nonconcentrated markets (i.e. ones with four-firm concen-tration ratios less than 75%) the Justice Department aba’-lenges mergers with the following shares:

Acquiring AcquiredFirm Firm

5% 5%10%15%20%25%

4%3%2%1%

See Merger Cuidelines, U.S. Department of Justice, May 30,1968.

line of commerce definition and assumes that the ag-gregate of the many products and services suppliedby banks represents a meaningful product line foranalysis of market competition.’1

Economic Analysis of Line of Commerce

Definition

The definition adopted by the Court in 1963 wasbased on a particular view of the market for bankservices: namely, that many bank products are de-manded jointly. In other words, it is possible toidentify “clusters” or “bundles” of services demandedby customers for which banks compete.’2 Such de-mand may result because of transportation costs andtransaction costs (including the cost of obtaining in-formation) which makes it costly or impractical forcustomers to deal with more than one institution.

Banks, however, compete in many different productmarkets and in different geographic market areas.Commercial banks participate principally in marketsfor financial assets. Banks demand customer depositswhich they invest in a variety of earning assets. Cus-tomers using demand accounts are, in turn, supplieda transaction service. Customers holding time depositsare provided an intermediation service — funds areinvested in interest-earning assets, Banks also supplyvarious types of credit, trust services, safe depositservices, correspondent services, etc. Each of theseactivities can be identified as an individual “output”of a bank. One can argue that each “output” is sold in

11The use of such concentration ratios is not necessarily ad hoc.Their use has both theoretical and empirical support in theliterature. Nevertheless, it is reasonable to conclude that theuse of such ratios, essentially a result of data scarcity, hasunfortunately guided research efforts as well. For a summaryof the empirical evidence for banking, see Stephen A.Rhoades, Structure and Performance Studies in Banking: ASvmmary and Evaluation, Staff Economic Studies 92 (Boardof Governors of the Federal Reserve System, 1977) andGeorge J. Benston, “The Optimal Banking Structure: Theoryand Evidence,” Journal of Bank Research (Winter 1973),pp. 220-37. For a criticism of such “conduct/structure/per-formance” studies, see Yale Brozen, “Concentration andProfits: Does Concentration Matter?” The Antitrust Bulletin(Summer 1974), pp. 381-99. See also Harold Demsetz, “In-dustry Structure, Market Rivalry, and Public Policy,” Journalof Law and Economics (April 1973), pp. 1-9.

i2~4~alternative argument holds that banks have offereddiverse services in the past because they have been prohib-ited from paying interest on demand deposits since 1933.Customers holding large demand deposit balances receive“implicit interest” in the form of other services offered belowcost to depositors. In other words, competition resulted ininstitutions, faced with prohibition on direct payment ofinterest, offering implicit interest in the form of services,such as low or zero service charges, drive-in facilities,branches, and occasionally gifts (porcelain china, silverwareand calculators, for example).

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FEDERAL RESERVE SANK OF ST. LOUIS

a distinct market defined in terms of specific groups ofbuyers (for example, by location of customer, or ma-turity and denomination of the particular loan). There-fore, choosing the appropriate measure of bank “out-put” is a difficult task.’3

The above reasoning suggests that the usefulness ofthe line of commerce definition adopted in the Phila-delphia case should be determined on empiricalgrounds. Although the “department store” or “clusterof service” approach may be valid in some instances,the concept is completely irrelevant for many readilyidentifiable bank “products.” For example, an indi-vidual seeking a mortgage loan will choose an institu-tion primarily on the basis of the price of the loan(the interest rate); the package of other servicesoffered by competing institutions is not pertinent inthis decision.

Measuring the extent of competition between differ-ent types of institutions in a product line must bebased upon the degree of substitution between prod-ucts of these institutions. In economic terms, theimportant issue is the magnitude of the “cross-elas-ticity” of demand between individual products offeredby financial institutions.” The higher the cross-elas-ticity between the products of banks and thrifts, thegreater the substitution and the stronger the argu-ment for including the outputs of these institutionsin the same industry or the same product line. Thecluster approach used by the Supreme Court assumesthat the degree of substitution between lines of com-merce (thrift output and bank output) is “small.”For example, if institution A (say, a thrift) increasesthe (explicit or implicit) interest rate on savings de-posits while institution B (a bank) keeps its ratesunchanged, the volume of business transferred bylocal customers from bank B to thrift A rises with themagnitude of the cross-elasticity of supply. The other

FEBRUARY 1981

services offered by bank B (for example, checkingservices), however, may preclude a significant transferof business between institutions. Since both thriftsand banks can now offer transaction accounts, thedegree of substitution between their respective out-puts will increase.15

Bank regulatory agencies have emphasized the“locally limited” customer in analysis of bank mergersand acquisitions. As such, regulators have tended tostress the services provided to individuals and smallbusiness customers. Since most large commercial andindustrial customers have access to national andregional markets, competition for these accounts isintense. Empirical estimates of the relevant cross-elasticities for retail and small business customers inlocal banking markets, however, are difficult to obtain.Regulatory ceilings on interest rates interfere withobtaining good estimates of these magnitudes. As pre-viously mentioned, competitive forces have resultedin institutions competing by means other than thepayment of explicit rates of interest. Institutionslocated in different market environments offer differ-entiated clusters of outputs. Differing degrees ofbranching restrictions across governmental jurisdic-tions, for example, may affect the form of implicitinterest paid to consumers.

Even before the MCA, other structural changessince the last Supreme Court ruling on a merger case(1974) had cast doubt on the validity of the bankingregulatory agencies’ approach to competition. Theasset and deposit liability growth of thrifts has out-paced that of banks over most of the periods from1960-79 (tables 2 and 3). It is unlikely that the pre-vious degree of substitution between the outputs ofbanks and thrifts has remained constant since thePhiladelphia definition in 1963. Retail customers inlocal banking markets have reacted to significant fi-nancial developments in the 1970s. Inflation, interestrate ceilings, and new instruments such as moneymarket certificates, money market funds, ATS ac-counts and telephone transfer accounts, have all con-tributed to an increased degree of substitution be-tween services offered by banks and non-bankinstitutions. The nationwide legalization of thrifttransaction accounts further weakens the argumentthat banks have a clear advantage in attractingcustomers.

15

Accumulated evidence prior to the MCA supports the viewthat customers already treat time and savings accounts ofbanks and thrifts as substitutes. For a review of the empiricalevidence before 1970, see Gary C. Gilbert and Neil B.Murphy, ‘‘Competition lletween Thrift Institutions and Com-mercial Banks: An Examination of the Evidence,’ Journalof Bank Research (Summer 1971), pp. 8-18.

tm3flesearchers’ views have varied considerably in their theoret-

ical definitions of the appropriate banking output measure.See Stuart I. Creenbaum, “Competition and Efficiency in theBankinq System — Kmpirical Research and Its Policy luspli—cations,’ The Journal of Political Economy (Supplement:August 1967), pp. 461-79, and Michael A. Klein, “A Theoryof The Banking Firm,” Journal of Money, Credit, and Bank-ing (May 1971), pp. 205-18.

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The “cross-elasticity” of demand is defined as a measure ofthe relationship between the demand for one firm’s outputwhen the price of another firm’s output changes (when allother things remain the same). The cross-elasticity betweengoods 1 and 2 is given by the equation

= % change in quantity of good I demandede % change in price of good 2If e is less than zero, the outputs are normally considered“complements.” If e is greater than zero they are consideredsubstitutes. The degree of substitution can he gauged l,y thema~iitude of this coefficient: higher positive cross-elasticitycoefficients correspond to greater degrees of substitution.

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Table 2~

1960- 1965- 1970- 1975-1960 1965 1970 1975 1979 1965 1970 1975 1979

--.- --..~--- —---..

cOMMERCIAL BANKS (insuredBunnesS loans $ 43.1 ~ 71.2 $112.2 $174.3 $256.0 10.6% g.s% 9.2% 10.1%

only)Mortgage3 28.7 73.1 134.8 243.2 11.5 8.1 13.0 15.9

Consurn~Ioans 26.4 4~•~ 66.0 106.0 186.4 11.6 ~ 9.9 15.1

secUrities 60.4 59.2 61.6 117.6 136.8 -0.4 0.6 13.8 3.9U S. TrE.aSati and arflcyState and boa’ securIhes 17.3 36.5 69.4 101.8 131.9 17.3 12.5 6.0 6.7

OThc! ~ssoiS BOA 111.6 194.1 ~i0.4 441.7 6.8 11.7 98 9.2-...-

TOTAL 256.3 375.4 576.4 944.7 i.395•~ ~.9 9.0 10.4 10.2

SAVINGS & LOAN ASSOCbATI0N.~$ 60.1 $110.3 $150.3 5273.6 5 475.8 12.9% 6.4% 13.1% 14.3%

;naastment secu~.”eS 4.6 13.0 30.9 46.5 10.0 11.9 16.8 10.8

Other assetS 6.8 11.9 12.6 28.8 57.0 11.7 i.5 17.5 18.6

TOTAL 71.5 129.6 176.2 338.3 579.3 12.6 6.3 13.9 14.4

MUTUAL SAVINGS BANKSMort.Y.QCS S 26.7 S 4$.~ $ 57.8 $ 77.2 $ 96.9 10.7% 5.4% 6.0% 6.4%

.J~.covern.~~secunhieS 6.2 3.2 7.6 - 2.6 10.5 8.5 12.6

Slate ar.d local securiLios .7 2 1.5 2.9 l3.C 9.2 51.0 17.3GorpDr~a~ddoer .sccurities 5.1 5.2 12.9 28.0 37.1 0.4 p0.0 16.3 7.3Qmer assets 1.9 2.6 9.6 16.8 ~.5 12.1 13.9 15.1

TOTAL 40.6 58.2 79.0 121.1 163.4 ~•5 6.3 8.9 7.8

~o,sn~outstanding ~ ~ $ 8.1 $ 14.1 $ 28.2 $ 53.1 13.0~ 11.7% 14.6% 17.2%CIREDIT UNIONSOther assetS 13 2.5 as 12.7 14.3 9.4 20.8 6.5

iicI~ I u d ‘Ii n ‘rein )iu)h tin. \h.ri I, W~i)md Octii’’ 9S0.

The presumed “seftied consumei preference” for for e%amPIe~in some states that limit branching forbanks over competiug institutiOfl5 has become less banks. second, new tecbnolo~’conrinues to alter theand less evident.” First, S&Ls have unique advantages traditional methods of marketing financial services.over banks. They enjoY statewide branching privileges~ Electronic banking is the most obvious example of

— the declining importance of locational convenience inbanking_ie~ one-stop banking. Automated telleri~the settled consumer preference notion adopted

1n theCourt conilicts with ec0000lie theory. Mieroeeomtomfie theory machines, automatic payroll check deposit, bankingexplains that a eonsmfler’s choice between the outputs of liv mail and point_of-sale terminals expand the geo-many banks is based on the relative prices of those out— ‘ . .

puts All preferences are “settled,” or stable, in that they are graphic scope of competition among depository mnsti-considered to he independetit of price. Such stable prefer- tutions for what was once considered the locallyemsees, however, do not preclude changes in response tochangiiIg reIauve prices. limited customer. 7

FEDERAL RESERVE BANK OF ST. LOUIS

FEDERAL RESERVE BANK OF ST. LOUIS FEBRUARY 1981

Table 3Composition of Deposits (billions of dollars)

End of Period Annual Growth Rates

1960- 1965 1970- 1975-

1980 1985 1970 1975 1979 1965 1970 1976 1979

COMMERCIAL BANKS

Demand $155.7 $1838 $247.2 $319 a $429.5 3.4% 6.1% 53% 7.7%Ttme and savings 73.3 147.7 235.3 4555 6565 150 9.8 14.1 9.8

TOTAL 2290 331 5 482.5 775.2 1,086 0 7 7 7.8 9.9 8 8

SAVINGS AND LOANASSOCIATIONS

Savings capital $ 62 1 $110.4 $146.4 $2857 $4702 12,2% 58% 14.3% 133%

MUTUAL SAVINGS BANKSTime and savings $ 36.1 $ 52.1 $ 7L2 $109 a $144~1 76% 64% 9.0% 72%Other .3 3 .4 6 1.9 54 48 66 351

TOTAL 362 52.4 71.8 109.9 146.0 7.6 64 8.9 7.4

CREDIT UNIONS

Member savings $ 50 $ 92 $ 153 S 330 $ 862 31% IOS% 163% 142%

SOURCES. Banking a d Monetary Staftsta a, 1941 1970’ Annual Statist, at D eats 19 1-1975 a ‘3 19 4 1978 Federal Reserve Bulletin March 1980 and October 1980 arid Watwnal Fact Book of Mutual Saving

8an ing 1976 and

1980.

Legal Issues Connecticut, that point may well he reached whenand if savings banks become significant participants

The Supreme Court case that most recently ad- in the marketing of hank services to commercialdressed the relevance of thrifts in competitive analy- enterprises. But, in adherence to the tests set forthsis was the Connecticut National Bank case in 1974.17 in onr earlier bank merger cases, . . such a point

has not yet been reached?8

A lower court had found that savings banks were“fierce competitors” of banks in certain markets, The The Court’s emphasis on competition for commer-Supreme Court, however, reaffirmed the line of com- cial business has led some analysts to speculate that,merce definition adopted in the Philadelphia case, even with the passage of the MCA, thrifts will stillmaintaining that commercial banks offer a unique he excluded from the Federal Reserve’s competitivecluster of services that distinguish them from other analysis of mergers and acquisitions. Indeed, the quan-institutions. The Court in particular emphasized that titative impact of the new law is greater with respectthere was a lack of significant competition between to the array of services offered to retail customers. Allbanks and mutual savings banks for commercial depository institutions in the nation may offer NOWaccounts, accounts, but not to commercial and business enter-

There was, however, an indication that the Court prises.1°Mutual savings banks are now permitted torealized that the Philadelphia definition’s usefulness _______

was declining. For example, in the Connecticut case iiibid.the Court stated: i9NOW accounts are to he mnde available only to an individual

At some stage in ,the development of savings banks ~r~i ~ aI~t f?r~jdin~~~’PhihmJit will be unrealistic to distinguish them from com- which is not for profit.” These depositors have been definedmercial banks for purposes of the Clayton Act. In hy the Federal Reserve Board to include individuals, sole

proprietors, husbands and wives operating unincorporatedbusinesses, local housing authorities, residential tenant se-

iTUnjted States v. Connecticut National Bank, 418 U.S. 656 eurity deposits, independent school districts and redevelop-1974). ment authorities.

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FEDERAL RESERVE BANK OF ST. LOUIS FEBRUARY 1981

extend business loans (up to 5 percent of total assets)to firms within 75 miles of their main office, but sincemost mutual savings banks are located in the East,their competitive impact will be limited to easternmarkets. Likewise, the commercial lending authoritygranted to mutual savings banks applies only to sav-ings banks with federal charters. In addition, ex-panded services to corporations would remain gener-ally unavailable from S&Ls. The MCA, however, per-mits Federal S&Ls to invest in commercial paper andcorporate debt securities (up to 20 percent of assets).

Whether these specific changes will be sufficient toalter the line of commerce definition in court cases isan unsettled issue. Although the competitive impactof the MCA on competition for commercial customersmay not be viewed as substantial in quantitative terms,any marginal increases must be considered significantsince these new powers allow additional entrants intomarkets for these services.

SOME ALTEIIT4AT1VES

Many analysts believe that a different approach tothe analysis of competition among depository institu-tions is called for.2°To a limited degree, banking au-thorities have already begun to introduce the influenceof thrifts into their analysis.ui The question still re-mains, however, how the impact of increasing thriftcompetition should be weighted in the analysis. Inother words, how would the line of commerce be“unbundled?” Should commercial banks, mutual sav-ings banks and S&Ls together encompass a line ofcommerce, or should individual product markets ofthese institutions be analyzed? Several options areavailable.

Add Thrifts to Line of CommerceFramework

One alternative is simply to include thrift institu-tions as direct competitors of banks; in other words,treat thrifts as commercial banks for purposes of a lineof commerce definition. Concentration ratios wouldcontinue to be the most likely candidates as the keyproxies for measuring competition under such an ap-proach. Including thrifts into the analysis would liber-alize merger and acquisition policy to some degree.Since concentration ratios would be diluted by de-posits or assets of thrifts, the number of possible bankmergers meeting the Justice Department’s currentmerger and acquisition “standards” would beincreased.22

Unfortunately, this approach suffers from the sameflaws that exist with the general use of “commercialbanking” as a line of commerce definition. Becausesignificant differences exist in the asset and liabilitypowers between banks and thrifts, competition variesacross relevant product lines. Likewise, the varyingforms of financial structure observed among geo-graphic areas of the country (location of mutual sav-ings banks in the East and different thrift and bankbranching laws across states, for instance) make suchconcentration ratios difficult to apply consistently.

Maintaining the line of commerce framework byincluding thrifts but continuing to rely on aggregatedmarket share statistics also suffers from major eco-nomic flaws. As argued above, the relevant cross-elasticities among products of banks and thrifts havebeen altered by changes in technology and a greatnumber of financial innovations in recent years. Like-wise, as regulations on interest rate ceilings are re-moved over the next six years, financial institutionswill undoubtedly “unbundle” their own services. Com-petition among institutions will result in independentlypriced services and these prices will more closelyapproximate the marginal costs of their provision.

Maintain Current Approach With “Subjective”Addition of Thrifts

Another alternative is to maintain the current ap-proach of including only banks in concentration analy-sis, except in cases where thrifts are seen as “signifi-cant competitors.” In such cases, thrifts would be used

22For an evaluation of the impact of including thrift depositsin market concentration ratio calculations for banking mar-kets in New York and New Jersey, see Roger E. Alcaly andRichard W. Nelson, “Will Including Thrifts in the BankingMarket Affect Mergers,” The Banking Law Journal (April1980), pp.346-Sl.

9

20See, for example, Henry C. Wallieh and \Valter A. \mnrvel,“Evolution in Banking Competition,” The Bankers Magazine(November/December 1980), pp. 26-34, and CommercialBanking as a Line of Commerce: An Examination of itsEconomic and Market Validity in Commercial Bank Anti-trust Law, prepared by Colembe Associates Inc. for theAssociation of Bank Holding Companies (December 1980).

21For recent Federal Reserve actions see (1) approval for themerger of The Bank of New York with Empire NationalBank, Federal Reserve Bulletin (September 1980), pp. 807-09; (2) denial for Republic of Texas Corporation to acquireCitizens National Bank of Waco, Federal Reserve Bulletin(September 1980), pp. 787-89; (3) approval for Key Banks,Inc., to acquire the National Bank of Northern New York,Federal Reserve Bulletin (September 1980), pp. 781-82; (4)denial for Texas Commerce Bancshares, Inc. to acquire TheFirst National Bank of Port Neches, Federal Reserve Bulletin(July 1980), pp. 584-85; (5) denial for Republic of TexasCorporation to merge with Fort Sam Houston Bankshares,Inc., Federal Reserve Bulletin (July 1980), pp. 580-82; (6)approval for Fidelity Union Bancorporation to acquire Gar-den State National Bank, Federal Reserve Bulletin (July1980), pp. 576-79; (7) denial for United Bank Corporationof New York to acquire The Schenectady Trnst Company,Federal Reserve Bulletin (January 1980), pp. 61-64.

FEDERAL RESERVE BANK OF ST. LOUIS FEBRUARY 1981

in calculating market share data. In essence, this isthe approach that the banking regulatory authoritiesare now using and, given the uncertainties of theMCA’s impact, is the likely route they will follow dur-ing a transition period. This methodology providesenough flexibility to accommodate regional differencesin market structure, but is not likely to be legallysatisfying given its subjective framework. In addition,it suffers from the same problems as the current lineof commerce definition of lumping together the manyoutputs of banks and thrifts into one aggregatemeasure.

Unbundle Financial institution Products

A third alternative, more consistent with economictheory, is to disaggregate the traditional line of com-merce (defined as commercial banking) into spe-cific subcategories. Though this strategy would moreaccurately reflect the actual competitive situation, itwould increase the difficulty of assessing the impacton “overall” competition. Regulators would first befaced with the problem of assigning weights to thecompetitive effects of a merger or acquisition acrossproduct lines. Since institutions are multi-productproducers, it is possible that competition among firmsmay be lessened for some outputs but not for others.For example, two local banks proposing to mergemight produce a monopoly on local trust services butstill generate vigorous competition with many otherfinancial institutions for checking and savings deposits.Depending on the relative weights assigned to thecompetitive effects across product lines (which wouldcontinue to be measured by concentration ratios),the disaggregated product approach might result ina more restrictive stance against mergers andacquisitions.

A second limitation to the disaggregation approachis the lack of detailed statistics measuring some prod-

uct lines. Each product line might correspond to adifferent geographic market. Correspondent bankingservices, for example, would have to be analyzed interms of larger geographic regions (e.g., a state),whereas small business loans would be analyzedwithin a more localized market. One would have toidentify both customers of such product lines and thefinancial institutions offering close substitutes for thisapproach. Practical data problems would thereforelimit the degree of disaggregation possible.

CONCLUSION

Although Supreme Court cases to date have con-sistently upheld “commercial banking” as a distinctline of commerce definition in bank merger cases, thefoundation of the Court’s reasoning has eroded since1963. Significant market changes since the last Su-preme Court case (1974) cast doubt on the practiceof evaluating mergers and acquisitions as narrowly asthe traditional analysis requires.

With the passage of the Monetary Control Act,there is greater reason to depart from the establishedtradition of treating commercial banking as an exclu-sive line of commerce in antitrust analysis. A morebroadly defined line of commerce would increase thenumber of mergers and acquisition proposals meetingantitrust standards. On the other hand, a disaggre-gated approach to analyzing the product lines of banksand thrifts would more accurately scrutinize proposalsfor actual anticompetitive effects. Such changes inproduct and geographic market definitions will haveimportant implications for the future structure andcompetitive performance of the financial industry.Although the proper analytic approach is still evolv-ing, increased thrift competition will certainly playa more significant role in the evaluation of futurebank mergers and BHC acquisition proposals.

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FEDERAL RESERVE BANK OF ST. LOUIS FEBRUARY 1981

AppendixDefining Banking Markets

The most crucial element of competitive analysis inmany bank merger and acquisition eases is the definitionof the relevant local banking market. In many proposalsanalyzed by the Federal Reserve, the only dispute (overwhich approval or denial of an application depends) isover the appropriate market definition. Given the tendencyof the courts in recent years to rely on simple market sharetests, it is important to understand the logic and reasoningbehind the delineation of banking markets.

There are both conceptual and empirical problems indefining banking markets. The conceptual problems dealwith describing the relationship between “sellers” and“buyers,” so that an area can be defined as a market.The most basic and widely accepted concept for analyz-ing markets is “cross-elasticity of demand.” The cross-price-elasticity is a measure which summarizes the rela-tionship between the change in price of any one firm’soutput and the amount of business done by others (seefootnote 14 in text). If an increase (decrease) in the priceof one firm’s service results in a significant increase (dc-crease) in the sales of another, the two may be consideredto be subject to the same market forces — and are in thesame market. Economic theory does not tell us, however,what magnitude of the cross-elasticity should he used forsuch determinations. It does tell us that if competitionexists, output prices of these firms tend to equalize to pricesequivalent to the marginal cost of providing these services.

Implementing this conceptual framework in actual case-work is not easily achieved. Since price data to measurecross-elasticities are difficult to obtain, a number of otherproxies are used in defining a market, Most of these indi-rect measures of cross-elasticity center around judgmentsabout the “reasonable interchangeability” of the productsof finns. The “products,” of course, have been defined asthe general category of banking services (total depositsbeing used as a proxy for such output) to conform to theline of commerce definition adopted by the courts.

Although there is no uniformly accepted method ofdefining banking markets, the following items are impor-tant factors in the process of defining markets.

A. Structural information — the size and location ofcompeting institutions and branches, other statuteswhich restrict actual or potential entry (restric-tive chartering practices and branching laws, forexample).

B. Distance factors and commuting patterns — thedistance between relevant competing institutions,traffic flows, the quality of roads and other nat-ural boundaries which affect access to competinginstitutions.

C. Political boundaries — county and state boundaries(banking laws which restrict branching within

such boundaries adds some weight to using thesedefinitions).

D. Geographic distribution of advertising — radio,television and newspapers.

A useful proxy for interaction of suppliers of bankingservices and customers is primary service area (PSA) data.The PSA is normally defined as that geographic area con-tiguous to an office from which 80 percent of the dollaramount of that office’s deposits is derived. Applicants arefrequently requested to submit comparable data forother services (e.g., demand deposits, savings deposits,loans, etc.).

Confusion reigns among bankers about the differencebetween PSAs and markets as economists define them. Thelack of overlapping service areas between banks does notnecessarily mean that banks are located in distinct marketareas. The two are not equivalent concepts. All of the fac-tors mentioned above may make the market substantiallylarger than a bank’s PSA. In other words, two banks,competing in the same market, need not have commoncustomers or overlapping PSAs.

For those wishing to review the literature on the ana-lytics of defining banking markets, the following sourcesare suggested:

David D. Whitehead, “Relevant Geographic BankingMarkets: How Should They Be Defined?” FederalReserve Bank of Atlanta Economic Review (January/February 1980), pp. 20-28.

Paul R. Schweitzer, “Definition of Banking Markets,”Banking Law Journal (September 1973), pp. 745-62.

Ira Horowitz, “On Defining the Geographic Markets inSection 7 Cases,” Federal Reserve Bank of ChicagoProceedings of a Conference on Bank Structure andCompetition (1977), pp. 169-82.

Charles D. Salley, “Uniform Price and Banking Mar-ket Delineation,” Federal Reserve Bank of AtlantaMonthly Review (June 1975), pp. 86-93.

Douglas V. Austin, “The Line of Commerce and theRelevant Geographic Market in Banking: WhatFifteen Years of Trials and Tribulations Has TaughtUs and Not Taught Us About The Measure of Bank-ing Structure,” Federal Reserve Bank of Chicago Pro-ceedings of a Conference on Bank Structure andCompetition (1977), pp. 185-209.

Steven A. Mathis, Duane G. Harris and Michael Boehlje,“An Approach to the Delineation of Rural BankingMarkets,” American Journal of Agricultural Economics(November 1978), pp. 601-08.

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