Modern Financial Systems: Theory and Applications

CHAPTER 19

Banking Market Structure Models and Empirical Research

This chapter first examines how market conditions influence financial intermediaries’ interest rates, whether charged on loans or paid on deposits. These topics are part of a larger question: how a financial intermediary’s profitability is affected by its economic environment. Early banking theory explained that the size of the banking system was determined mechanically as a fixed multiple of available cash reserves. This original explanation was enriched substantially when Gurley and Shaw (1960) and Tobin (1956) emphasized that financial institutions’ portfolios are determined by profitability considerations. Following the lead of Gurley-Shaw and of Tobin, the theory presented in this chapter argues that financial intermediaries of most types—banks, insurance companies, mutual funds, and other financial services providers—manage their operations in attempts to maximize profitability.³⁴⁹ After examining some equilibrium models of banking markets, the chapter considers recent empirical studies and their relations to existing theory.

While the analytical and empirical issues considered in this chapter are variations on the theme of profit maximization, their details vary according to the type of intermediary. In the case of a bank, one principal question is whether the bank can increase its profitability by raising additional funds and relending them. In the case of an insurance company that seeks to expand its insurance ...