Concentration in the Banking Industry. Good Sign or Negative Trend?

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Generally speaking, a high level of concentration in any market or industry is not a desirable situation. Why is this? For one thing, it tends to lead to higher industry prices, as you probably know from your recent HughesNet internet prices. This is a direct result of saturation within the ISP industry. It also leads to shrinking outputs, with a smaller consumer surplus as the market grows in concentration. Even if there is no collusion within the industry, the concentration will still cause all of this. Firms in such industries or markets, however, earn higher profits for a long period.

Concentration in the Banking Industry

So if the concentration in any market or industry is bad for consumers, does the same hold true for the banking sector? Most developed and industrialized countries have a high concentration within the financial sector, especially the banking industry. To put things in perspective,

Here are some figures from non-US markets:

• In Finland, the top three banks control over 85% of the market.
• In Norway, the top three banks have control of 84% of the market.
• The top 3 banks in New Zealand and South Africa control 77% of the market.

The Banking Industry in the United States of America

Things are very different in the financial sector in the United States. In fact, the U.S. banking sector has a relatively low level of concentration as compared to the markets above. In the U.S. the top 3 banks control only 19% of the market.

So what does this mean for the industry? Is low concentration the American market a good or bad thing? Let’s examine this in more detail.

Concentration in the U.S. Banking Industry: A Good Thing

With the breakdown of the financial system in 2008 still fresh in our minds, concentration within the banking industry may not be a bad thing for American consumers. According to a study by the NBER (National Bureau of Economic Research), a high level of concentration can lead to higher levels of stability within the banking industry. In fact, countries with a concentration level of 72% or above had fewer instances of banking failure.

How Can Concentration be Beneficial?

Strictly within the banking industry, there are 3 key benefits of a higher level of concentration.

They are as follows:

• Larger banks can easily diversify into different sectors. Even if one sector, for example, real estate, takes a turn for the worse, the bank can easily adjust in the other sectors. On the other hand, smaller banks that only focus on one or two sectors are more vulnerable to adverse conditions.
• Higher concentration levels mean more profits for the banks that dominate the industry. On the flip side, the interest rates and service fees will go up. However, banks, and by extension, depositors remain safe from economic shocks. If banks have higher franchise values, they will be less willing to take financial risks that may be damaging.
• Its easier to monitor a few large banks in the industry than numerous small ones. Regulatory bodies and financial watchdogs have an easier task keeping an eye on dominant banks. Larger banks will also have similar operations and systems, adding to the uniformity.

So What Does This Mean for America?

As we mentioned above, the U.S. has a relatively low concentration level within the banking industry. This is one of the reasons the United States sees more economic fluctuation than more concentrated markets, according to experts. According to the NBER, banking failure and bank size have a negative correlation. As the banks’ sizes increase, the number of banking failures comes down. But that’s not to say there aren’t any negative effects.

How Can Concentration be Negative?

Higher levels of concentration within any industry usually lead to lower levels of competition. Prices and fees will also rise with increasingly concentrated industries. This is part of the reason we see higher HughesNet bundle prices every year. And banking is no exception. In the banking industry, more concentration means higher interest rates. Investors start balking at risky investments. There’s also the fact that less profitable niches may be ignored by more popular banks in favor of the more profitable ones. You can see this in many industries, like the aviation industry which only flies popular routes.

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