Hempel and Fischer, “Rate Dispersion in Retail Banking – Do Local Factors Still Matter?”

1. 11th Conference of the ECB-CFS NetworkSession IVA: Retail Finance and SMEs Discussion by Alexander Popov(European Central Bank)October 21, 2008

2. Motivation: cross-border trade in retail banking still small compared to what is expected; no pan-European model in place even for the largest European banks while banking competition has intensified within countries, no evidence is available on the effect of local market power Main idea: characteristics of national markets used in recent studies to explain this phenomenon; insufficient -> go in the direction of Guiso et al (2004) and Huang (2006) Main hypothesis: Local factors matter for retail financial integration Draw policy conclusions – is interest rate dispersion higher across regions within a country, or across countries? Main findings: Local market power of banks matters for short-term deposits and credit to enterprises 1 st. dev. increase in competition leads to widening of interest rate spread by between 16 and 19 basis points. Local factors do not matter for consumer loans and retail mortgages Hempel and Fischer, “Rate Dispersion in Retail Banking – Do Local Factors Still Matter?”

3. General remarks Choice of sample/country Focusing on Germany only prevents from evaluating the relative importance of local vs. national markets Regional banks only – but market behavior will matter depending on whether dominant bank in local market is local or national Rate calculations – yield curve? 10% rate on a 3-month deposit is not the same as a 10% rate on a 12-month deposit (in loans to enterprises, for example, you are using “gross interest rates spreads”). Hempel and Fischer, “Rate Dispersion in Retail Banking – Do Local Factors Still Matter?”

4. Specific remarks Construction of indices How are the HH and Lerner index calculated? By assets? Clarification needed! If by assets, then you are mis-measuring true concentration. For example: 5 banks, all equally big asset-wise, but one does most of the retail banking and the others do mostly commercial banking Index can still not capture true local competition For example, imagine region Bundesregion 17 Three equally big cities: Bad Schon, Bad Sehrschon and Bad Wunderbahr A different bank has monopoly in each city – HH will tell you that there is triopoly while in fact there are 3 local monopolies! Empirical methodology Income per capita, unemployment and insolvency rates may be collinear with bank sector concentration. (Black and Strahan (QJE 1996), Beck et al (WB 2007)). Regression without those? Correlation matrices? Omitted variable bias – industrial concentration (Cetorelli (Fed Chicago 2002)) Hempel and Fischer, “Rate Dispersion in Retail Banking – Do Local Factors Still Matter?”

5. Specific remarks (continued) Demand considerations Proxies for demand: human wealth, non-human wealth and demographics. Only first one present. Instrument Number of banks in 1986 not a good instrument in a dynamic market (not a good analogue to Guiso et al. (2004) procedure where banking structure is fixed over time). First stage regressions? Interpretation of results Bank local power matters for short-term deposits and credit to enterprises Political economy explanation for fact 2? (Incumbents teaming with banks to prevent new entrants by charging them high rates?) But why would enterprises be restricted in taking credit from local sources only? Wouldn’t they take trade credit if loan rates became too high? Or VC? No effect on consumer loans – counterintuitive? Why are consumers more mobile in their decisions than enterprises? Hempel and Fischer, “Rate Dispersion in Retail Banking – Do Local Factors Still Matter?”

6. Main idea: examine the sensitivity of investment to bank loans and trade credit Thus, circumvent econometric challenges associated with studying the sensitivity of investment to cash flows (Fazzari et al vs. Kaplan and Zingales) Focus on SMEs as the most obvious firms to whom bank and trade credit matter Investigate causality channels Main hypothesis: Desired loans > actual loans for constrained firms => Investment not sensitive to bank loans for those Desired loans > actual loans for constrained firms => Investment sensitive to bank loans for those Carbo-Valverde et al. “Bank Lending, Financial Constraints and SME Investment”

7. Data 30,897 Spanish SMEs (less than 250 employees) from Amadeus 1994-2002 Total of 278,073 observations Main findings Investment is sensitive to bank loans for unconstrained firms Investment is sensitive to trade credit for constrained firms Main contribution Moves away from the investment-cash flow sensitivity literature Uses Granger predictability tests Carbo-Valverde et al. “Bank Lending, Financial Constraints and SME Investment”

8. General remarks Size Why SMEs? Sounds sexy, but… more theoretical motivation needed Some descriptive stats – how important are SMEs to the Spanish economy? Definition of SME broad – non-monotonic relationship to size? Split the sample Defining constraints Non-direct measure of constraints can generate large classification errors and weaken the validity of existing tests for liquidity constraints (Japelli (1990)) Firms may have preferences over investment sources (Hines and Thaler) – can the Euler equation method account for a possible pecking order? Carbo-Valverde et al. “Bank Lending, Financial Constraints and SME Investment”

9. Specific remarks Data issues Customary to exclude certain industries subject to specific regulations (utilities, financial sector) Industry characteristics: use a Rajan-Zingales criterion to exclude industries for which external finance doesn’t matter. Empirical procedure The power of a Granger test diminishes quickly as the sample is reduced. 3 lags in a 9-period panel? Robustness tests Is investment still non-sensitive to bank loans for constrained firms once you take out the sub-sample of fully-constrained firms (2,426)? Carbo-Valverde et al. “Bank Lending, Financial Constraints and SME Investment”

10. Main idea: examine the determinants and performance effect of VC on firms Test whether VC is a substitute for multiple lending relationships (firms get VC to avoid the rent-extracting behavior of the main bank) Focus on SMEs, but distinguish by age and growth potential Use an econometric technique (matching) to circumvent the fact that venture capitalists are targeting more productive firms Main findings: Firms with multiple banking relationships are less likely to use VC Venture capital backed firms grow faster and spend more on R&D Main contribution: Look at SMEs Link between banking relationship and VC European data (Italy, Germany, and UK) Schaeck and Berger “Small and medium-size enterprises, Banking Relationships, and the Use of Venture Capital”

11. General remarks Three papers: 1) firm-level determinants of VC; 2) VC vs. multiple bank relationships; 3) VC-backed firms performance Survey data: 247 firms in UK, 162 in Italy and 152 in Germany. Small size! How representative in terms of size and banking relationships? (reported age and VC use only) How representative is the data regionally? As pointed out, VC-using firms tend to be clustered. How comparable is the environment in terms of economic dynamics? For example, share of new firms is 3.5% in Italy, 12.3% in Germany and 15% in UK (Rajan et al (JFE 2006)). SMEs – how important? Page 1: “23 million SMEs account for 99% of all companies in Europe” (Observatory for European SMEs (2004)) If true, then we need to change the definition! Negates contribution #1 Given that 99% of firms are SMEs, doesn’t it make sense to distinguish among other lines – for instance, YIC vs. non-YIC? Schaeck and Berger “Small and medium-size enterprises, Banking Relationships, and the Use of Venture Capital”

12. Specific remarks Section on facts and figures: added value? Account for the banking structure – local factors matter (Hempel and Fischer). Maybe VC is used rather than multiple banking relationships because only 1 bank is available locally? Too little variability in unobservable country factors once Italy is dropped (3% of firms obtaining VC – so it should be). In particular, accounting for difference in the supply of VC and its determinants becomes tricky. Supply of VC: use variation in the prudential regulation of institutional investors across countries and over time… but 2 countries? Schaeck and Berger “Small and medium-size enterprises, Banking Relationships, and the Use of Venture Capital”

13. Selection issues: Only observe firms with banking relationships if they 1) desired bank credit, and 2) were not denied bank credit Only observe firms that get VC if they 1) desired VC, and 2) were not denied VC. 4 selection criteria! Increase in employment is an indicator variable – no information about economic significance Instrument: dummy=1 if bank on firm’s board – can also be correlated with the decision to use VC. Schaeck and Berger “Small and medium-size enterprises, Banking Relationships, and the Use of Venture Capital”