The Efficiency Cost of Market Power in the Banking Industry: A Test of the 'Quiet Life' and Related Hypotheses

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Abstract
Traditionally, concerns about market concentration have focused on mispricing and the restriction of output relative to competitive markets. This type of loss is typically measured by the standard welfare triangle. The associated welfare losses usually motivate antitrust policy. This paper focuses on another type of loss from concentration and market power that may be much larger. Firms that are not subject to rigorous market discipline may take some of their market power rewards not as higher profits, but as a "quiet life" in which cost efficiency suffers. Similarly, managers of firms in concentrated markets may exercise expense preference motives and worsen cost efficiency in this way. The question of whether increased concentration and market power reduces firm cost efficiency may be particularly important to policy analysis of the banking industry. The recent wave of mergers among large banking organizations, particular "horizontal" or "within-market" mergers between banking organizations situated in the same local markets raises concerns about the increase in local concentration. If the "quiet life" and related efficiency-reducing effects of concentration are substantial, they might be considered in the merger approval process along with the traditional concerns about the welfare loss due to mispricing and the safety and soundness of the consolidated enterprise. The authors estimate how bank efficiencies are affected by local market concentration, controlling for number of factors, including regions, state regulation, size, and corporate governance. The banks in the sample represent over two-thirds of all U.S. banking assets. The basic hypothesis tested is that the market power exercised by firms in concentrated markets provides a price "cushion" above the competitive level that allows firms to avoid the rigors of cost minimizing without necessarily exiting the industry. The authors' empirical application sugges
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