by Joseph T. Hallinan

1. Wall Street Journal 8/26/03 Article“Greener Pastures: Boosting Your ReturnsAt a Small-Town Bank” by Joseph T. Hallinan

2. 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.

3. 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 nation’s 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.

4. 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. • rDbe the interest rate a bank pays on retail deposits. • rMbe 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.

5. “Loan Rich” Small Bank: rD> rM Interest Rates Retail Deposit Supply Loan Demand Quantities Loans = Retail Deposits

6. “Loan Rich” Large Bank: rD= rM Interest Rates Retail Deposit Supply Loan Demand Retail Deposits Wholesale Deposits Quantities Loans

7. “Deposit Rich Banks: rD= rM Interest Rates Retail Deposit Supply Loan Demand Loans MM Securities Quantities Retail Deposits

8. 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.

11. 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 model’s 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.