1. STCPM title A model of bank price and nonprice competition with endogenous expected loan losses Filipa Lima Paulo Soares de Pinho Emerging Scholars in Banking and Finance Contemporary Issues in Financial Markets and Institutions Cass Business School – City University London 9 December 2009

2. A model of bank price and nonprice competition with endogenous expected loan losses – an application to Portugal Emerging Scholars in Banking and Finance, Contemporary Issues in Financial Markets and Institutions Cass Business School – City University London, 9 December 2009 2 Outline I – Motivation II – Literature review III – The Model IV – The data V – Main findings

3. A model of bank price and nonprice competition with endogenous expected loan losses – an application to Portugal Emerging Scholars in Banking and Finance, Contemporary Issues in Financial Markets and Institutions Cass Business School – City University London, 9 December 2009 3 I – Motivation  Most studies on bank competition are based upon margins which are not net of credit losses  Banks make their pricing decisions considering not just operational and financial (funds) costs but also the expected percentage credit loss on the loan  Banks make decisions not just on their loan (interest rate) prices but also on their acceptable levels of risk  Actual quantities depend upon not just prices but also on the bank’s decision concerning acceptable expected credit losses

4. A model of bank price and nonprice competition with endogenous expected loan losses – an application to Portugal Emerging Scholars in Banking and Finance, Contemporary Issues in Financial Markets and Institutions Cass Business School – City University London, 9 December 2009 4  Expected credit losses absent from either the “traditional” “reduced-form” approach and the “structural form” approach to model and measure banking competition  Some recent studies introduced effective credit losses as a control variable, including Bikker and Haaf (2002), Bikker et al. (2006) and Casu and Girardone (2006). Dermine (1986) treated them as exogenous.  This implies that either margins or Lerner indices may be upward biased and that high risk could wrongly be taken market power  The partial endogeneity of credit risk has mostly been ignored. Main exception is Liang (1989), by simultaneously estimating a profit function and a risk function. Martín-Oliver et al. (2007), provide a valuable contribution by estimating loans’ risk premium and adjusting loans’ marginal costs accordingly. II – Literature review

5. A model of bank price and nonprice competition with endogenous expected loan losses – an application to Portugal Emerging Scholars in Banking and Finance, Contemporary Issues in Financial Markets and Institutions Cass Business School – City University London, 9 December 2009 5  Bank’s use their own internal credit risk model to determine each borrower’s probability of default (PD) and loss given default (LGD). Expected Loss = PD × LGD × Exposure  Stiglitz – Weiss (1981) expect banks to control their exposure to individual customers (credit rationing)  We model banks as deciding the maximum acceptable expected loss on a loan (this is usually done by setting a scoring cutoff)  Given a certain distribution of borrowers and their losses, setting the maximum expected loss also determines the average expected loss for that group of borrowers. Thus, we use expected average credit losses as the control variable III – The model

6. A model of bank price and nonprice competition with endogenous expected loan losses – an application to Portugal Emerging Scholars in Banking and Finance, Contemporary Issues in Financial Markets and Institutions Cass Business School – City University London, 9 December 2009 6 III – The model: modelling expected loan losses

7. A model of bank price and nonprice competition with endogenous expected loan losses – an application to Portugal Emerging Scholars in Banking and Finance, Contemporary Issues in Financial Markets and Institutions Cass Business School – City University London, 9 December 2009 7  Demand for Loans:  Demand for Deposits:  Objective function: st:  control: r l it ; r d it ; B it ;  it III – The model: main equations

8. A model of bank price and nonprice competition with endogenous expected loan losses – an application to Portugal Emerging Scholars in Banking and Finance, Contemporary Issues in Financial Markets and Institutions Cass Business School – City University London, 9 December 2009 8  Example: Price and expected loss of Loans With the additional assumptions:  Similar equations for price of deposits and for branches  We take “conjectural variations” as mere deviations from perfect competition III – The model: FOC and conjectural variations

9. A model of bank price and nonprice competition with endogenous expected loan losses – an application to Portugal Emerging Scholars in Banking and Finance, Contemporary Issues in Financial Markets and Institutions Cass Business School – City University London, 9 December 2009 9 We use a Banco de Portugal proprietary database that combines both accounting and statistical data for each single bank operating in Portugal. Complete and accurate characterisation of the individual banks and their activities, both in terms of outstanding amounts and at the margin. Period 1997 - 2004 We obtained data for new loans and deposits granted/accepted at each period (quarter), thus being able to use effective marginal prices rather than average prices as in most studies. We use each bank’s average effective losses during the period as a proxy of their expected losses Data on rivals: for interest rates and expected losses, weighted average of the (n – 1) rivals; for branches, sum of all (n – 1) rivals’ branches. IV – The data

10. A model of bank price and nonprice competition with endogenous expected loan losses – an application to Portugal Emerging Scholars in Banking and Finance, Contemporary Issues in Financial Markets and Institutions Cass Business School – City University London, 9 December 2009 10 IV – The data: interest rate differentials

11. A model of bank price and nonprice competition with endogenous expected loan losses – an application to Portugal Emerging Scholars in Banking and Finance, Contemporary Issues in Financial Markets and Institutions Cass Business School – City University London, 9 December 2009 11 The system of non-linear equations using the full information maximum likelihood technique (FIML); Starting values were obtained from single equation estimates of L it and D it before estimating all the equations jointly (fixed effects) White (1980) robust estimates for the variance-covariance matrix of the parameters. IV – The data: estimation procedures

12. A model of bank price and nonprice competition with endogenous expected loan losses – an application to Portugal Emerging Scholars in Banking and Finance, Contemporary Issues in Financial Markets and Institutions Cass Business School – City University London, 9 December 2009 12 V – Main findings Low own price elasticities Deposits more inelastic than loans

13. A model of bank price and nonprice competition with endogenous expected loan losses – an application to Portugal Emerging Scholars in Banking and Finance, Contemporary Issues in Financial Markets and Institutions Cass Business School – City University London, 9 December 2009 13 V – Main findings Low own price elasticities Deposits more inelastic than loans Deposits and loans more sensitive to own rates than to rivals’

14. A model of bank price and nonprice competition with endogenous expected loan losses – an application to Portugal Emerging Scholars in Banking and Finance, Contemporary Issues in Financial Markets and Institutions Cass Business School – City University London, 9 December 2009 14 V – Main findings Low own price elasticities Deposits more inelastic than loans Deposits and loans more sensitive to own rates than to rivals’ Branches more effective on deposits

15. A model of bank price and nonprice competition with endogenous expected loan losses – an application to Portugal Emerging Scholars in Banking and Finance, Contemporary Issues in Financial Markets and Institutions Cass Business School – City University London, 9 December 2009 15 V – Main findings Low own price elasticities Deposits more inelastic than loans Deposits and loans more sensitive to own rates than to rivals’ Branches more effective on deposits Banks’ loan quantities sensitive to other banks’ credit policies

16. A model of bank price and nonprice competition with endogenous expected loan losses – an application to Portugal Emerging Scholars in Banking and Finance, Contemporary Issues in Financial Markets and Institutions Cass Business School – City University London, 9 December 2009 16 V – Main findings Low own price elasticities Deposits more inelastic than loans Deposits and loans more sensitive to own rates than to rivals’ Branches more effective on deposits Banks’ loan quantities sensitive to other banks’ credit policies Size and market concentration: + collusive behaviour in the loans’ market

17. A model of bank price and nonprice competition with endogenous expected loan losses – an application to Portugal Emerging Scholars in Banking and Finance, Contemporary Issues in Financial Markets and Institutions Cass Business School – City University London, 9 December 2009 17 V – Main findings Low own price elasticities Deposits more inelastic than loans Deposits and loans more sensitive to own rates than to rivals’ Branches more effective on deposits Banks’ loan quantities sensitive to other banks’ credit policies Size and market concentration: + collusive behaviour in the loans’ market In the deposits’ market: size and market concentration have opposite effects

18. A model of bank price and nonprice competition with endogenous expected loan losses – an application to Portugal Emerging Scholars in Banking and Finance, Contemporary Issues in Financial Markets and Institutions Cass Business School – City University London, 9 December 2009 18 V – Main findings Low own price elasticities Deposits more inelastic than loans Deposits and loans more sensitive to own rates than to rivals’ Branches more effective on deposits Banks’ loan quantities sensitive to other banks’ credit policies Size and market concentration: + collusive behaviour in the loans’ market In the deposits’ market: size and market concentration have opposite effects Higher concentration leads to lower impact on rival’s credit policies (relationship banking effect?)

19. A model of bank price and nonprice competition with endogenous expected loan losses – an application to Portugal Emerging Scholars in Banking and Finance, Contemporary Issues in Financial Markets and Institutions Cass Business School – City University London, 9 December 2009 19 V – Main findings Low own price elasticities Deposits more inelastic than loans Deposits and loans more sensitive to own rates than to rivals’ Branches more effective on deposits Banks’ loan quantities sensitive to other banks’ credit policies Size and market concentration: + collusive behaviour in the loans’ market In the deposits’ market: size and market concentration have opposite effects Higher concentration leads to lower impact on rival’s credit policies (relationship banking effect?) Larger banks (MS) tend to have higher impact on rival’s credit policies

20. A model of bank price and nonprice competition with endogenous expected loan losses – an application to Portugal Emerging Scholars in Banking and Finance, Contemporary Issues in Financial Markets and Institutions Cass Business School – City University London, 9 December 2009 20 V – Main findings Low own price elasticities Deposits more inelastic than loans Deposits and loans more sensitive to own rates than to rivals’ Branches more effective on deposits Banks’ loan quantities sensitive to other banks’ credit policies Size and market concentration: + collusive behaviour in the loans’ market In the deposits’ market: size and market concentration have opposite effects Higher concentration leads to lower impact of rival’s credit policies (relationship banking effect?) Larger banks (MS) tend to have higher impact on rival’s credit policies High inertia on the branching variable

21. A model of bank price and nonprice competition with endogenous expected loan losses – an application to Portugal Emerging Scholars in Banking and Finance, Contemporary Issues in Financial Markets and Institutions Cass Business School – City University London, 9 December 2009 21 V – Main findings Low own price elasticities Deposits more inelastic than loans Deposits and loans more sensitive to own rates than to rivals’ Branches more effective on deposits Banks’ loan quantities sensitive to other banks’ credit policies Size and market concentration: + collusive behaviour in the loans’ market In the deposits’ market: size and market concentration have opposite effects Higher concentration leads to lower impact of rival’s credit policies (relationship banking effect?) Larger banks (MS) tend to have higher impact on rival’s credit policies High inertia on the branching variable Extension of branching network relies heavily on loans’ margins

22. A model of bank price and nonprice competition with endogenous expected loan losses – an application to Portugal Emerging Scholars in Banking and Finance, Contemporary Issues in Financial Markets and Institutions Cass Business School – City University London, 9 December 2009 22 THANK YOU! Questions? Questions?