US Consumer Banking Approaches Perfect Competition

US Banks are seeing a larger number of new entrants into the industry. Chime, a mobile-only bank, has opened two million online checking accounts and is adding more customers each month than Wells Fargo or Citibank. Firms from outside traditional consumer banking including Square, Goldman Sachs (Marcus), and Robinhood are entering the industry as well. The consulting firm CG42 said in a recent report on the vulnerability of retail banking that it expects the ten largest banks to lose $344 billion in deposits over the next year. All these signs point to an industry that is approaching perfect competition.

Perfect competition is a prevailing market condition in which the market price is beyond the control of individual buyers and sellers and requires a number of conditions. These conditions include free entry and exit, a homogeneous product, and a large number of buyers and sellers. In this post I will discuss the ways in which consumer banking has come to meet these conditions along with the implications of perfect competition for banking. It is important to note that no real market exists in absolute perfect competition, and the sense of the word discussed here is rather loose in comparison.

Meeting the Conditions of Perfect Competition

As the demographic of the United States shifts younger, customers have started to move away from reliance on traditional brick and mortar branches and instead prefer app-based services with lower fees. This has led to an erosion of entrance and exit costs. Additionally, venture capitalists are setting records with funding of “neo-banks”, investing $2.5 billion through the second quarter of 2019 – for reference, the previous high was only $2.3 Billion in all of 2018. Both the shift in preferences away from physical branches and the availability of funding  have paved the way to eliminate much of the cost for market entrants allowing the newcomers to undercut the incumbents.

A paper entitled Competition in Banking by Carol Ann Northcott published in 2004 lists the ways that banks differ to include reputation, product offerings, and the extensiveness and location of their branch networks. Scandals such as Wells Fargo’s fake-account scandal and the Financial Crisis of 2008 have tarnished the reputation of big banks and, along with the disappearing importance of branches, have helped to push consumer banking closer towards a homogeneous good.

While the number of commercial banks in the US has been steadily decreasing since 1984, there are still 4,605 banks in the US as of the end of second quarter of 2019 according to the St. Louis Federal Reserve. Additionally, the FDIC found only 6.5 percent of households in the United States were unbanked in 2017. In other words, more than 118 million US households have access to a bank account. By these metrics, the condition of a large number of buyers and sellers is clearly met.

Implications of Perfect Competition for Consumer Banking

Banks contribute greatly to growth by facilitating production in other industries and promoting capital accumulation through the supply of credit. In a perfectly competitive market, banks are profit-maximizing price takers such that costs and prices are minimized. In this situtation, the greatest quantity of credit will be supplied at the lowest price. A paper by Besanko and Thakor examines loan and deposit markets and finds that loan rates decrease and deposit rates increase as more banks are added to the market. These findings support the theoretical prediction that a a more competitive environment results in the largest quantity of credit being supplied at the lowest price.

On the other hand, Northcott finds that a banking system that exhibits some degree of market power may improve credit availility of certain firms and provide incentives for banks to screen loans which aids the efficient allocation of resources. In addition, she finds that market power may contribute to stability by providing incentives that mitigate risk-taking behavior and providing incentives to screen and monitor loans. Guzman also finds that the problems of the loan-borrower relationship may be exacerbated by more competitive market structures where information is not costlessly obtainable by the bank. Northcott finds no consensus in the literature on the optimal competive structure, but US consumer banking is moving towards perfect competition whether we like it or not.