In New Zealand there are often complaints that bank profits are exorbitant – especially given that profitability rose during a massive financial crisis. While there is an argument that banks are backed by a lender of last resort, and that they should pay for this (such as through a tax) this doesn’t tell us too much about profitability … remember a tax on bank transactions, or margins, will in part be passed on to borrowers and lenders through an increase in gross margins! Furthermore, the increase in profitability can be seen as banks taking into account the fact that lending was now more risky (after all, the LOLR only functions when the bank collapses – making a bad loan and losing some money is still a cost that is fully faced by trading banks!).
Still, I’m not actually going to discuss any of this. I’m hear to say that the increase in banks margins during the crisis and the corresponding drop as financial conditions have improved can be analysed in the same we economists analyse any sector. And it may well point to a special type of “tacit collusion” in the banking sector.
We have talked about tacit collusion on the blog before, it is a fascinating issue – note that it is’t explicit collusion, it is just an illustrate of how the individual choices of banks regarding their strategy is setting price may in some situation mimic collusive outcomes. The key example I’ve provided was the price of Nurofen but there are many examples. If we have the type of competition modeled by Rotemberg and Saloner, then firms will tacit collude during periods of “low demand” and this collusion will break down during periods of high demand – when the size of the “pie up for grabs” is larger. Given that banks compete on price, have a very clear idea of when a shift in demand is for their firm or for the market as a whole, and don’t face significant capacity constraints, this type of argument is actually pretty relevant!
So what does this tell us about bank lending behaviour? Well in a situation where we do have multiple banks, lending behaviour during booms may act as if the industry is competitive, but during slow downs it will act as if it is more of a monopoly – as a result, the quantity of credit provided will fall more sharply during a slowdown and the price of credit will be higher compared to the case when the industry is just magically always competitive. Interesting stuff!