Bank Mergers: The Case of Contestable Markets

By Marc Law, PhD candidate, Economics, Washington University, St. Louis,
and Johanna Francis, Researcher, The Fraser Institute

Here are some things the Minister of Finance should consider in deciding whether to allow the proposed bank mergers. The common perception is that competition among banks is necessary to ensure prices are competitive and consumers are not over-charged. Under this presumption, if a market is characterized by many banks, it is competitive, if characterized by few, it is less so, and if characterized by only one or two it is not competitive—implying consumers must pay higher prices for reduced services.

There are two basic problems with this perception. First, operationally it is very difficult to set a boundary for what constitutes the banking industry—that is, how broadly the market should be defined for banking products or services. Second, an ideally competitive market—one characterized by many banks, none of which have the ability to influence prices—may not be the best benchmark for policy recommendations in the banking industry.

Economic theory contends that, in general, if a firm has market power—the ability to influence prices—then the firm is able to set its prices higher than the competitive market price. The existence of firms with market power is a traditional justification for government intervention in an industry. Yet, clearly, how much market power an individual firm possesses depends critically on how the “market” is defined; the broader the definition used, the less market power any particular firm will have.

For example, if bank services are defined as savings accounts at the Bank of Montreal, because only one firm supplies the service, that firm, namely, the Bank of Montreal, has a monopoly. If, however, we define the market for savings accounts to include all banks, then the Bank of Montreal’s market share is reduced. Alternatively, if we define the market for savings accounts to include any bank, trust company, credit union, or cooperative (i.e., any firm that offers savings accounts) then the market share of individual banks is again diluted. Further, there are a variety of close substitutes for savings accounts such as GICs and mutual funds that might also be included in the market definition for savings accounts, diluting the market power of individual banks yet again.

Because it is not at all obvious at what point to draw the line —whether to restrict the market for savings accounts to national banks, to national banks plus credit unions, etc., the use of market power as an index of competition within an industry is suspect. This calls into question the ability, in practice, of public policy to remedy the “problems” caused by market power.

Moreover, empirical studies suggest the Canadian banking industry may be legitimately characterized as a “contestable market.” A contestable market is typically characterized by a small number of firms, where even though each firm has a large market share, it nevertheless charges competitive prices. It is the threat of potential competitors which keeps these firms in line in terms of pricing, not the actual existence of other firms.

Considering the contestable market argument in the context of the Canadian banking sector, suppose the two mergers (between the Bank of Montreal and the Royal Bank, and between the Canadian Imperial Bank of Commerce and the Toronto Dominion Bank) go forward. Assuming the banking sector is a contestable market, the fact that only three firms (the two merged banks, plus ScotiaBank) as opposed to five (if the market is narrowly restricted to the big five banks) are servicing the market need not result in less competition and higher prices for consumers. If entry into the banking sector is open to both foreign and domestic firms, then the threat of such entry may deter the incumbent banks from raising their prices. An effort on the part of the incumbent banks to raise prices could be met by entry of a foreign bank, or the expansion of other financial institutions such as credit unions. Hence, the impact of the mergers on competitiveness in the banking industry may be very small if free entry into the industry is permitted.

What we need is not to prevent the mergers because of worries of market dominance and over- pricing, but to open up the Canadian banking industry to both foreign and increased domestic competition. To do this, we need to eliminate the restrictions on foreign banks, (e.g., domestic capital requirements) and on domestic financial institutions (e.g., restrictions on offering a broader scope of services). These restrictions create a barrier to entry and thus in themselves, with or without the mergers, make the Canadian banking industry less competitive than it otherwise would be.

We urge the Minister of Finance to consider carefully these sound economic principles in making his decision.

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Last Modified: Wednesday, October 20, 1999.