Wall Street Journal 8/26/03 Article

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Wall Street Journal 8/26/03 ArticleGreener
Pastures Boosting Your ReturnsAt a Small-Town
Bank
by Joseph T. Hallinan
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• Are there systematic differences in the interest
  rates that different types of banks pay on retail
  deposits and retail loans?
• The article shows that rates paid on retail
  Certificates of Deposit (CDs) are often higher at
  small, rural banks than at big urban ones located
  in the same approximate area.
• The article notes that not all small, rural banks
  pay more deposit interest, but many do.
• In addition, the small banks that pay higher
  interest on deposits appear to charge higher
  interest on retail loans, such as mortgages.

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• The article states Big banks say they try to be
  competitive with rural rates, but acknowledge
  that they often fall short. J. Lanier Little of
  Wells Fargo, the nations fourth largest bank,
  states We rarely aspire to consistently pay the
  highest rates in town.
• What might explain the difference between small
  and large bank rates?
• A recent research paper by Kwangwoo Park and I
  Harming Depositors and Helping Borrowers The
  Disparate Impact of Bank Consolidation examines
  this issue.
• We conclude that it is large banks access to
  lower cost wholesale funding that can explain the
  difference.

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• Here is a simplified illustration of the main
  idea. (Ignore capital requirements, reserve
  requirements, and taxes, and administrative costs
  of making loans and issuing retail deposits.)
• Let
• rL be the interest rate a bank charges on
  loans.
• rD be the interest rate a bank pays on
  retail deposits.
• rM be the interest rate on money market
  investments (LIBOR).
• It is assumed that all banks can invest in money
  market securities that pay the wholesale interest
  rate rM .
• However, only large banks have access to
  wholesale funding sources. It is assumed that
  they can borrow at rate rM and the supply of
  these wholesale funds is perfectly elastic.

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Loan Rich Small Bank rD gt rM
Interest Rates
Retail Deposit Supply
Loan Demand
Quantities
Loans Retail Deposits
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Loan Rich Large Bank rD rM
Interest Rates
Retail Deposit Supply
Loan Demand
Retail Deposits
Wholesale Deposits
Quantities
Loans
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Deposit Rich Banks rD rM
Interest Rates
Retail Deposit Supply
Loan Demand
Loans
MM Securities
Quantities
Retail Deposits
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• An implication is that large banks should never
  pay more than LIBOR on retail deposits, though
  small banks sometimes will.
• Loan rich small banks should pay more on retail
  deposits than large banks.
• Our study analyzes the retail deposit interest
  rates paid by large multi-market banks (LMBs) and
  small banks based on a Bank Rate Monitor, Inc.
  survey of 130 MSAs over the years 1998 to 2003.
• Table 1 shows that LMBs pay MMDA and CD rates
  consistently less than LIBOR. Moreover, Table 2
  reports that LMBs MMDA and CD rates are lower
  than those of small banks in the same market in
  all cases for the years 1998 to 2003.

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• Conclusions
• LMBs tend to set retail interest rates uniformly
  across local markets and have access to wholesale
  funding. Due to market-extension mergers, they
  increasingly compete with small, single-market
  banks.
• If LMBs wholesale funding advantage is large,
  the model shows that market extension mergers
  enhance competition for retail loans but reduce
  competition for retail deposits.
• Empirical evidence from retail MMDA and CD rates
  supports LMBs funding advantage and the models
  results.
• The model may apply to other industries where
  large firms set prices uniformly across markets
  and compete with smaller, single-market firms
  that face financing constraints.