Vertical Integration to Avoid Contracting with Potential Competitors: Evidence from Bankers’ Banks

1. Vertical Integration to Avoid Contracting with Potential Competitors: Evidence from Bankers’ Banks James A. Brickley, James S. Linck and Clifford W. Smith, Jr.

2. Fundamental Business Decision • Should the firm make or buy its inputs? • With respect to banking • Loan participation, check clearing, asset/liability management, credit card services, advisory

3. Make or Buy? • Most past research focused on: • Transaction costs, property rights, market power, government regulation • Empirical support for: • Integrate to avoid hold-up problems associated with firm-specific investment • Market power and government regulation • However • Significant variation exists in settings where these are relatively unimportant

4. Our Focus • Make vs. buy decision in the banking industry in the latter part of the 20th century • Geographic deregulation and technological change • Community banks exposed to greater competition from larger banks on which they previously relied for correspondent services • Industry formed business cooperatives called “bankers’ banks” for correspondent services • What explains it? • Specific investment relatively unimportant • No noticeable change in market power in these markets • Banking becoming less (not more) regulated

5. Business Cooperative • Firms jointly own a primary supplier or distributor Supplier Firm A Firm B Firm C Distributor

6. Examples of Business Cooperatives • Agriculture • Hardware stores • Grocery stores • Drug Retailing • Moving Industry • Mutual Insurance • Joint Ventures • Banking

7. Ace Hardware • Retailer-Owned Cooperative wholly owned by independently operated store owners • 2007 • 4,600 Ace Stores in all 50 states and 70 countries on six continents • $12 billion in sales

8. Business Cooperatives and Organizational Alternatives • Purpose: Economies of scale in the production / acquisition of inputs or the distribution of their products • Organizational alternatives • Market transactions • Long-term contracting • Vertical integration

9. Contracting CostsBusiness Cooperatives • Benefits • Maintains local asset ownership • Avoids hazards of contracting between to independently owned firms • Costs • Free-riding in monitoring and decision making of jointly owned company • Collective action problems & owner conflicts • Antitrust

10. General Economic Prediction • Expect to see cooperatives in environments where • Costs of independent contracting are high • Benefits of local asset ownership are large • Costs of cooperative organization are low (free-riding, collective action issues and antitrust)

11. Objectives of this Paper • General Objective • Provide new evidence on the determinants of vertical organization and the economic reasons for business cooperatives • Specific Objective • Provide evidence on the choice that small banks make between long-term contracting with a large bank (correspondent banking) & joining a business cooperative (bankers’ bank) • Test predictions on when and why bankers’ banks first formed and who uses their services

12. Why are Bankers' Banks Particularly Interesting • Unique opportunity to provide evidence on vertical choice. • In contrast to industries with long-standing, static organizational patterns, we can observe both important environmental changes and variation in organizational responses. • This allows us to identify more clearly the economic factors that are likely to affect vertical organization and to provide evidence on their explanatory power. • The downside is that our evidence is from one regulated industry.

13. Changes in the Banking Industry 1935-2005 (Table 1)

14. Banking Industry Deregulation(Table 2)

15. US. Banking Industry NowSmall Banks Still Around (Table 3)

16. California Banking Industry NowSmall Banks Still Around (Table 3) Past Research: Small (“community”) banks are most prevalent in small urban and rural areas where it is important to give office managers broad decision authority and ownership incentives (e.g., Brickley, Linck, Smith (2003))

17. Changes in the Banking IndustryEffects on Vertical Organization • Prior to 1975 all community banks had correspondent relations with large money center and/or regional banks • Massive regulatory and technological change • Increased likelihood that community banks will compete with large banks over retail and commercial customers • Increased likelihood that a partner in a correspondent relationship will disappear due to a takeover or merger

18. Changes in the Banking IndustryEffects on Vertical Organization • These developments reduced the apparent willingness of community banks to: • Share information with large banks (e.g., about customers in loan participations) • Make specific investments in correspondent relationships

19. Changes in the Banking IndustryThe Bankers’ Bank • Chartered under national and state banking laws • First bankers’ bank was formed in 1975 (Minnesota) • Today there are 21 bankers’ banks providing services to 1000’s of community banks throughout the United States

20. Hypotheses • Bankers’ Banks were an organizational response to the increased contacting costs of correspondent banking between a community bank and large bank • Achieve economies of scale • Maintain local asset ownership • Alternative: Contract with an independent provider

21. Hypothesis 1 and 2When and Why They First Arose • Bankers’ banks are most likely to be formed • In markets with a lot of community banks • Sufficient customer base • In markets with most prior regulation • The change in potential competition drove the need for the bankers’ bank • Thus, states that were mostly strongly regulated

22. Hypothesis 3 and 4Who Uses a Bankers’ Bank • Community banks that are most likely to face competition from large banks are the most likely to join a bankers’ bank • Community banks located in areas where the competition from large banks is likely to change • Near large metropolitan areas or in midsize urban areas • Community banks with a large fraction of loans based on “hard” information or with large customers • Larger fraction of construction loans and mortgage loans; customers with large deposits

23. Bankers’ Banks • National and state charters • Provide services only to other banks • Owned by their customer institutions, who also sit on the board • Can provide services to banks that are not shareholders • Shareholders receive preferred pricing, voting rights and dividends • Generally operate in more than one state • Unlikely to merge with another bank (individual banks cannot own more than 5% of the shares)

24. Bankers’ Banks (Table 4)

25. Typical Services • participation loans • cash letter services (check clearing) • sweep accounts • on-line correspondent banking • credit card services • international services • consulting services, audit and compliance services, investments • federal funds transactions • mortgage lending programs • direct loans to officers and directors of community banks

26. Hazards of Corresponding with a Large Potential Competitor • “Steal” your customers • Can have incentives to increase your costs (Salop & Scheffman (1987))

27. Bankers’ BanksTypical Marketing Statement “As corporate ‘megabanks’ expand, correspondent service to non-affiliated banks declines. Being commercial banks, such banks compete with other financial institutions, including their own correspondents, for business. In fact, you may find that they use information you provide them through the correspondent system to compete for your customers, furthering their interests at your expense! Since a bankers' bank cannot deal with the general public, such a conflict of interest cannot occur. Your interests are our interests.” Bankers’ Bank of Kansas, N.A. http://www.bbok.com/

28. Statement by a Community Banker “Many client banks today are faced with a paradox. To attract business, they must offer services that often are available through their large competitors operating as correspondent banks, but that places them in the unenviable position of doing business with the competition. Why did we invest in Bankers’ Bank? It is simple, we didn’t want to feed fees to the gorilla that could turn around and eat us up.” Thomas R. Burton, President and CEO Hamden Bank Springfield, MA

29. From the Bankers’ Bank Council A bankers’ bank is a correspondent bank that is owned, operated, and directed by the independent community banks it serves. Correspondent banking isn't a sideline for a bankers' bank - - it's our only business. And because many customers are also shareholders, we're answerable to them not only as our customers, but also as investors. Superior service and competitive pricing are the result.” …“Bankers' banks are the answer. Bankers' banks can do everything a major holding company correspondent bank can do, but bankers’ banks do not compete for your customers.

30. Empirical Results • First bankers’ bank in 1975, most (14 or 67%) formed in the 1980s (Table 3) • Coincided with relaxation of restrictions on geographic expansion (Table 2)

31. Regulatory Chg/Concentration (T5)

32. Independent Variables (Table 6)

33. Correlation of Ind Variables (Table 6)

34. Is a BB HQ’d in State? (Table 7)

35. Is Bank a BB Customer? (Table 8)

36. Is Bank a BB Customer? (Table 8)

37. BB Boards (Table 9)

38. BB Boards (Table 9)

39. Bank Represented on BB Board? (T10)

40. Bank Represented on BB Board? (T10)

41. Conclusions • Banking industry created an organizational innovation: The Bankers’ Bank • Serve the needs of community banks • Maintain incentives of local asset ownership while still achieving economies of scale without threat of stealing their customers • Cooperative in this setting • Costs of independent contracting high • Benefits of local ownership high • Costs of cooperative low: costs of free-riding low due to relatively frequent purchases