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Description
THIS PAPER USES THE SPANISH retail banking market as a case study to investigate the workings of the Law of One Price (hereafter, LOP). Although economic integration and price convergence has been a topic of interest in international economics (1) and there are several country level studies on price differentiation, (2) we are not aware of a comprehensive analysis of the LOP in retail banking as the one presented in this paper. Research on the level and the time dynamics of dispersion in loan and deposit interest rate has an academic interest since it will extend the existing limited knowledge on the workings of the LOP, as well as a practical one since the findings in one country member will be relevant to shape expectations about the future banking integration in the Euro area.
We take advantage of a large and unique database: quarterly quoted interest rates for 25 different banking products and for each individual commercial and savings bank during the period 1989 to 2003. Thus, we have information about marginal interest rates for both loan and deposit products. Combining different data sources we also obtain credit-risk-adjusted marginal opportunity costs for each loan product at the bank level. These marginal costs prove to be very relevant to explain the dynamics of loan interest rates over time and to obtain the long-term convergence value of the mark up over the marginal cost. In this way, the study of the LOP provides new insights on banking competition. The study starts in 1989 when the restrictions to the geographic expansion of savings banks, now half of the market, were removed and banking liberalization was completed. (3) Between 1994 and 1998 Spain was in a process of nominal convergence to meet the criteria to become a member of the Euro zone (interest rates fell from 15% to 3.5%). Over the period 1999-2003 Spain has been a full member of the Euro zone. Thus, each period offers a different scenario in terms of monetary and competitive conditions under which banks operate, which is worthwhile to study separately.
Interest rate differences will be evaluated under the absolute and the relative versions of the LOP. The absolute version states that products that are close substitutes for the buyers must be sold at the same price within the boundaries of a market. Thus, we want to test whether the products offered by Spanish banks are integrated into a single market (low interest-rate dispersion) or not (high interest-rate dispersion) and whether integration increases or decreases over time. Moreover, we perform an analysis of variance to evaluate, for the first time, how much of the observed dispersion in interest rates can be explained by product, bank, geographic market and time specific effects.
When the absolute version of the LOP does not hold, market integration can still be evaluated through the relative version of the law, which focuses on the dynamics of prices. Now, the LOP is said to hold when the null hypothesis that relative prices follow a random walk is rejected in favor of the alternative hypothesis of long-term price convergence (Asplund and Friberg 2001). The existence of a random walk implies that a new shock that widens the differences across relative prices persists over time and is not eliminated. On the other hand, price convergence implies that price dispersion can be a transitory phenomenon and the speed of convergence can be used as a measure of more or less adherence to the law. In our case, we will test whether a shock that widens the differences of interest rates with respect to their respective marginal cost (i.e., a shock in the markup) is persistent or it fades away over time and at what speed. Since the evaluation of high or low speed depends on the benchmark chosen, the paper examines if the speed increases or decreases over time within the 1989-2003 period, which includes years before and after Spain joined the Euro area.
The paper extends the analysis of interest rate convergence to the evaluation of banking competition. Interest rate dynamics may respond to external shocks common to all banks (the interbank rate) or to external shocks specific to each bank (credit risk of its loans). Second, interest rates may converge to a common interest rate across banks or to a different one for each bank. The response of prices to common shocks and the convergence to the same price are stronger evidence in support of the LOP. Our panel data on interest rates for each bank product, together with data on marginal costs of the loans, allow us to test which of the possibilities just described holds in the Spanish banking system. Moreover, the long-term convergence value of the interest rate relative to marginal cost provides an estimation of the long-term mark up (interest rate over marginal cost) for the bank product, that is, an estimation of the market power of banks. Repeating the calculation of mark ups for different time periods we can evaluate the evolution of banking competition over time. (4)
The paper is related to research on convergence of interest rates and evolution of market power in retail banking within European Union (EU) countries (Courvoisier and Gropp 2002, Angelini and Cetorelli 2003, Baele et al. 2004, Goddard, Molyneux, and Wilson 2004, Maudos and Fernandez de Guevara 2004). However, none of them use data on marginal interest rates and marginal cost (risk adjusted) at bank-product level or consider the distinction between transitory or permanent deviation of interest rates with respect to marginal cost. In fact, most published research in market power with individual bank-product data has used deposit interest rates (Berger and Hannan 1989, Hannan and Liang 1993) and little is known about the effect of credit risk premiums on the interest rates at the product-bank level. This owes to the fact that credit risk premium data are difficult to find. Using Banco de Espana Credit Register database, (5) we are able to obtain information on ex-post credit risk at bank and loan-product level that is used to estimate the ex ante risk-adjusted opportunity cost of the loans. Therefore, we provide estimates of risk-adjusted long-term mark ups for loans of different maturities. As far as we know, this is new in the literature and turns to be very relevant.
Our main results are the finding of substantial and persistent dispersion in interest rates set by Spanish banks, which implies the rejection of the absolute version of the LOP. The analysis of variance shows that banks' idiosyncratic effects are the principal determinant of the observed variation. These effects vary across loans and deposits and, for several loan products, their relative contribution to interest rate differentiation increases over time. If the same pattern can be expected at supra national level, European cross-country convergence in loan interest rates may not be the most appropriate benchmark to assess the process of retail banking integration. The results from testing the relative version of the Law show that the dynamics of loan interest rates are tied to the dynamics of the marginal costs of banks and that the convergence value of the markup in loans and deposits is positive (evidence of market power of banks). When we compare the results in different time periods we find a higher speed of convergence and a lower mark up in the period 1994-98, when Spain undertakes the process of nominal convergence to become a member of the Monetary Union. After 1999, when it is a full member, there are no further advances in the speed of convergence and competition, so being a member of the Euro zone has not contributed to a higher integration of national loan and deposit markets.
The rest of the paper is organized as follows. Section 1 contains a description of the data, empirical evidence that rejects the absolute version of the LOP, and the main sources of the interest rate dispersion behind such rejection. Section 2 contains a test of the relative version the LOP as well as estimates of the long-term mark up on each loan and deposit product. Section 3 concludes.
1. THE ABSOLUTE VERSION OF THE LAW OF ONE PRICE
1.1 Database
Data come from the confidential returns that commercial and savings banks send to Banco de Espana on interest rates for loan and deposit operations. The interest rate reported by a bank on a given product is the weighted average of interest rates set in all new operations made in that product during the corresponding quarter. The raw data has been filtered to eliminate inactive banks, banks with tiny market share (less than 1 over 10,000 in terms of total assets) and branches of foreign banks that concentrate mainly in the wholesale market. Thus, the database consists of interest rates on new loans and deposits made by around 200 different Spanish banks during 58 quarters (from 1989 to 2003) for 25 different products.
There are nine product classes, five loan and four deposit products. Discounting of receivables and credit lines are loans granted to firms, while personal loans and mortgages are granted to households. Loans at variable interest rate are granted to both. Loans are grouped by maturity: less than 1 month, from 1 to 3... |
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