Monetary policy under alternative bank market structures

Journal of Bankihg and Finance 7 (1983) 383--404. North-Holland

MONETARY POLICY U N D E R ALTERNATIVE BANK MARKET STRUCTURES* David D. VanHOOSE University of North Carolina, Chapel Hill, NC 27514, USA Received June 1982, final version received December 1982 The purpose of this paper is to derive and compare the short-run effects of monetary policy under both perfectly and imperfectly competitive banking markets. Within the context of a general equilibrium framework which emphasizes the demands for and supplies of financial assets, it is demo-nstratedih-fii-the structure of i~ahking markets Can liave a bea-rlng off the appropriate choice of policy targets and instruments. Specifically, the Federal Funds rate is shown to be a potentially ineffective target/instrument for policy under a competitive banking system, although it can be used to produce conventional short-run effects when banking markets are imperfect. In contrast, the level of currency and unborrowed reserves can be utilized as an effective target/instrument under either form of bank market structure.

1. Introduction

Although it generally is accepted that banking markets are not perfectly competitive, writers like Baltensperger (1980) and Niehans (1978) have preferred to build models which assume that banks are pure price-takers. This approximation seems unrealistic given the existence of factors which tend to produce concentrated local loan and deposit markets. One major factor leading to high market concentrations in banking is the fact that banking is one of the most heavily regulated of industries. Entry into local markets is severely restricted by chartering and branching requirements, and balance sheet regulations can lead to leverage disadvantages for potential entrant banks, further inhibiting the entry of new market participants. 1 A second key factor accounting for concentrated local loan and deposit markets is the existence of non-regulatory barriers to entry in those markets. Although studies like those reviewed by Benston (1973) have revealed relatively little *I have benefited greatly from the aid and encouragement of Arthur Benavie and Richard Froyen in the course of writing and revising this paper. I am also indebted to Michael Bradley, Robert Eisenbeis, William Lastrapes, Michael Salemi, Roger Waud, and two anonomous referees for this journal for helpful comments. Any errors are solely my own. tA complete discussion of the latter form of regulatory entry barrier is contained in Alhadeff (1974). As he notes, balance sheet regulation can create barriers to entry even when a 'free-entry' policy is undertaken. Rationales for regulation of the banking industry have been provided by Kareken and Wallace (1978), Buser, Chen and Kane (1981), and Bryant (1981). Bryant emphasizes regulation as a stabilizing factor, while Kareken and Wallace, and Buser, Chert and Kane view regulation as fundamentally related to the implicit pricing of deposit insurance. 0378-4266/83/$3.00 © 1983, Elsevier Science Publishers B.V. (North-Holland)

384

D.D. VanHoose, Monetary policy under alternative bank market structures

importance for the most traditional barriers of scale economies, capital requirements, and absolute cost disadvantages, banking is an industry in which the combined strength of various bank-customer relationships can be so great as to form product-differentiation-type barriers to entry, z Bank regulation and the differentiation barriers associated with bankcustomer relationships together act to produce locally concentrated loan and deposit markets and, based on the empirical evidence, high stability of market shares. 3 Concentration and market stability, in turn, generally are hypothesized to encourage monopolistic/monopsonistic behavior among market participants. 4 Assuming that this hypothesis holds true for banking, it would seem important to investigate the implications of such behavior for the conduct of monetary policy. Up to now, however, models of the financial sector have been built upon the assumption of rate-taking behavior in all banking markets. One of the goals of this paper is to consider the implications of a relaxation of this assumption. Although many local banking markets presently are far from perfect, it can be argued that the regulatory and behavioral factors which have produced market imperfections gradually are being eliminated. 5 This possible movement toward a more competitive banking system has been discussed in the literature, but relatively few attempts have been made to examine the implications of this development for the effectiveness of monetary policy. A recent exception is an article by Hester (1981), who claims that increased competition in banking will serve to undermine monetary control by reducing the stability of the banking system and thereby decreasing the range of policy options available to the Federal Reserve. As the profitability and soundness levels of banks decline, Hester argues, the Fed faces the prospect of imperiling financial institutions when it undertakes policy actions designed to contract the economy. Certainly, perfectly competitive banking markets cannot exist without the 2The behavioral and institutional implications of these relationships have been discussed by Hodgman (1963) and Wood (1975), and the importance of such relationships in determining the height of entry barriers is explored by Alhadeff (1974). 3A widely-cited work on this topic is that by Heggestad and Rhoades (1976). Like most other studies, it finds that banking markets tend to be highly concentrated and characterized by a high degree of firm stability. '~This hypothesis is in a continual state of flux in the industrial organization literature. The lack of agreement on the hypothesis, of course, stems from the wide varieties of conduct permitted under alternative models of firm behavior in concentrated markets. For a general discussion, see Scherer (1980). Bank structure/performance studies provide mixed evidence on the effects of market concentration; for a good review of these studies, see Heggestad (1979). 5Recent technological innovations in banking have been discussed widely in the literature, and it is generally agreed that they have occurred in part as a result of high interest rates coupled with continual regulation. As noted by Kane (1981), these and other innovations have usually led to a reduction in regulatory effectiveness. In addition, they have served as a catalyst for break-downs in traditional bank--customer relationships. For instance, the rapid growth of money market mutual funds has undoubtably blurred the distinction between local and national deposit markets in the minds of savers.

D.D. l,'anHoose, Monetary policy under alternative bank market structures

385

threat of failures, and Hester seems justified in contending that this threat is always present in the minds of policy-makers as they weigh the range of available options. Taking actions designed to contract the economy may, in a more competitive banking system, entail substantial costs which could act to constrain the Fed's behavior in conducting policy. However, another significant issue that has not been addressed is the implication of increased financial competition for the effectiveness of policy actions, irrespective of the presence of institutional constraints. Stated somewhat differently, are monetary policy instruments more or less effective in providing the desired real sector impulses under a competitive banking system as compared to one characterized by imperfect markets? This question must be answered before the full monetary policy implications of increased competition in banking can be addressed. The purpose of this paper is to derive and compare the short-run effects of monetary policy under both perfectly and imperfectly competitive banking systems. The approach adopted is similar in spirit to that taken by Aftalion and White (1977), although it differs in two important respects. First, this paper is concerned not only with the responsiveness of the banking system under different market structures but also with equilibrium adjustments throughout the various markets which together compose the financial sector of the economy. Second, the analysis conducted in the paper is designed to reflect more fully United States market conditions, and monetary policy procedures. In their paper, Aftalion and White concern themselves with national banking monopolies operating in economies in which a primary instrument of policy is the central bank discount rate. In contrast, banks which exercise monopoly power in this paper do so only in local markets: in addition, the monetary authority operates under a targeting procedure designed to peg either the Federal Funds rate or the level of currency and unborrowed reserves. Adapted versions of bank and financial sector models proposed by Benavie and Froyen (1982) are used as a basis for the analysis. This paper generalizes their approach in three ways. First, the short-run financial behavior of firms and households is modeled explicitly. Second, this paper distinguishes between loan and security holdings by banks, while, in the Benavie-Froyen model, all interest-earning assets are essentially a homogeneous bond. It will be demonstrated that this extension of their model turns out to have important implications for monetary policy. The third and most important generalization is an extension of their framework which enables a consideration of the macroeconomic policy implications of rate-setting behavior in bank loan and deposit markets. The next section of the paper lays out the microeconomic foundations for alternative models of the financial sector. Section 3 undertakes an analysis of the short-run effects of monetary policy actions when local banking markets

386

D.D. VanH oose, Monetary policy under alternative bank market structures

are imperfect, while section 4 considers policy effects under the assumption of perfect competition in all relevant markets. The final section summarizes the results and their implications, the most important of which is that the structure of banking markets can have a bearing on the appropriate operating targets and instruments to be used in conducting monetary policy. Specifically, the Federal Funds rate is shown to be a potentially ineffective target/instrument for policy under a competitive banking system, although it can be used td produce conventional short-run effects when banking markets are imperfect. In contrast, the level of currency and unborrowed reserves can be utilized as an effective target/instrument under either form of bank market structure.

2. Microeconomic foundations for short-run financial behavior

The analysis which follows abstracts from the issue of uncertainty. There are five types of agents operating in the financial sector: the U.S. Treasury, the Federal Reserve, households, non-bank firms, and banking firms. The Treasury issues government securities to finance expenditures, while the Federal Reserve holds securities and discounts as assets, issues liabilities in the forms of currency and bank reserves, and carries out policy by choosing operating targets in the financial sector and using instruments at its disposal to attempt real-sector stabilization. Households hold currency, deposits, and securities and borrow from banks, while firms hold currency, deposits, and physical capital, borrow from banks, and issue securities. Banks hold cash reserves and securities, loan to firms and households in local markets, borrow from the Federal Reserve discount window, issue deposits, and borrow or loan via the Federal Funds market. In accordance with most of the literature, it is assumed that government securities and securities issued by firms are perfect substitutes. The behavioral formulations which are constructed in this section are designed to emphasize the allocation of assets in the context of a short-run time horizon. The approach is to develop symmetric behavioral formulations for private economic agents which concentrate on demands for and supplies of financial assets. By adopting this approach, the models offered below ignore consideration of behavioral inter-relationships with respect to holdings of both physical and financial assets. However, this simplification is in keeping with much of the literature in this area, and it allows for a focused examination of the initial financial-sector adjustments to policy actions. 2.1. Financial behavior of households Each household maximizes the net return on its financial portfolio

D.D. VanHoose, Monetary policy under alternative bank market structures

rsS + roD - rLL-- B(S, D, L, A),

387

(1)

subject to its bank credit-augmented wealth constraint, S + D + A = W + L,

where

(2)

S D L A W

= securities, = b a n k deposits, =loans (bank credit), = currency, = household wealth, assumed fixed in the short run, rs =market-determined rate of return on securites, r o = deposit rate paid by banks, assumed completely flexible, r L =loan rate charged by banks, B(.) = a function describing the net resource cost associated with asset i, with Bij=O, i4:j; and B u >0, Vi. Household wealth is held fixed throughout the analysis. Endogenous variables are the four financial assets, which are allocated so as to achieve an optimal total return on the household's portfolio. The function B(.) includes all relevant costs (e.g., broker's fees, inventory and 'shoe-leather' costs, etc.) as well as benefits (e.g., acceptability in exchange, ease of convertability, etc.) derived from the portfolio. No restrictions are placed on the first partial derivatives of B; indeed, the first order conditions for a maximum of (1) require that the net marginal cost of currency holdings is negative, or that currency be held up to the point where each household perceives a marginal benefit from holdings of the only asset which offers no explicit rate of return. The assumption Bii > 0 indicates increasing net marginal cost (decreasing net marginal benefit) in allocating individual assets. There is no a priori way to determine the net effects of cost interactions in such allocations, hence the assumption Bij = O. Solution of the constrained optimization problem yields the following household asset demand and supply functions: 6 hsd=hsd('rs, rL, rD) , +

hDd= hDd ( rs, rL, rD),

had = hAd(rs, rL, ro).

(3)

Notice that the partial derivative signs indicated by the + or - over the independent variables are identical with the gross-substitutability attributes 6The algebraic derivations of these and other results reported in the paper are contained in a mathematical appendix which is available from the author.

388

D.D. VanHoose, Monetary policy under alternative bank market structures

typically postulated in macro models. Traditionally, gross asset substitution is assumed by model-builders, but the framework employed here provides a basis for such a specification.

2.2. Financial behavior of firms Firm behavior is symmetric to that of households. Each firm attempts to achieve an optimal short-run allocation of financial assets given a fixed level of physical capital. Specifically, the goal of each firm is to minimize net financial outlay

rsS + rrL-- roD + T(S, L, D, A),

(4)

subject to its balance sheet constraint

K.+D+A=S+L,

where

(5)

k = physical capital, assumed fixed in the short run, T(-) = a function describing the net resource cost faced by the firm in its financial dealings, with T~j =0, i4j; T, >0, Vi. All other variables are defined as in 2.1, except that securities are issued by the firm rather than being held as assets. The net resource cost function T is analogous to the B function for households. Solving for the firm's asset demand and supply functions yields

ss'=sss(rs,L, D), f D =fDa( rs, rL,' D) ,

f I~ =

f

-s" + + 1?,( rs, -rL, rD)" ,

IAd = SAd( rs, rL, rD).

(6)

Again, these functions indicate gross substitutability of assets.

2.3. Alternative forms of bank behavior 2.3.1. Bank behavior in perfectly competitive banking markets When banks are pure rate-takers in relevant markets, each maximizes profit,

rc= rtL + rsS + rQqD + G(X) -- roD -- rBB-- rrF - C(L, S, X, D, F, B),

(7)

subject to its balance sheet constraint,

L+S+X=(1-q)D+B+F,

where

(8)

D.D. VanHoose, Monetary policy under alternative bank market structures

X

= excess reserves,

F

= net Federal Funds borrowings,

B

=

389

Federal Reserve discount window borrowings,

G(x)= implicit

return derived from holdings of excess reserves, with G' > 0

and G " < O , Federal Funds rate,

?'F

rB q

= discount rate set by the Fed, = required reserve ratio set by the Fed, any interest return paid on holdings of required reserves, with the assumption r e < rs,

rQ

C(.)

=

bank's absolute real resource cost function, with Ci >0, Vi; Cij =0, i ¢j, and Cii > O, Vi,

and all other variables are defined as before. This model is essentially that of Benavie and Froyen, extended to include holdings of both loans and securities. Bank credit and securities are assumed to be imperfect substitutes, both for banks and for their customers. Certainly, this seems to be a justifiable assumption given the different characteristics of bank loans and securities. Loans require the utilization of very dissimilar resources by banks, and the decision by firms to issue securities or take out bank loans requires them to incur different levels of transactions costs. Clearly, loans and securities are imperfect substitutes for households, since one is a liability and the other an asset. Finally, the bank credit market is one in which the Fed does not directly operate, but which has effects on the real sector all the same; for this reason it seems doubly appropriate to consider the 'spill-over' impacts of policy actions between this and other markets. Solution of the constrained optimization problem yields the following bank asset demand and supply functions under conditions of perfect competition in all applicable markets: b s d -~- bsd( ~S' rL, rD, rF, rB,. +rQ, q),

b x d i-- b x d ( rs, r L, ro, re, ra, +r e, +

+

q), --

+

rT, ro, re, rn, rQ, q),

b[fl, : blff(rs,-rL, rD, rF, rB, +rQ, q), -

bDS= -hu..°, ~ +rs, +rL, -rD, +re, +rB, +r e, q), bFd= t'-[ rs, rL, rD, rF, rB, rQ, q). +, b ~a,

+

+

+

-

+

-

(9)

These functions correspond almost exactly to those derived by Benavie and Froyen, the only distinction being the disaggregation of their 'loan' asset into

390

D.D. VanHoose, Monetary policy under alternative bank market structures

loans (bank credit) and securities. The intuition behind the~ signs on the partial derivatives in these functions is fairly straightforward and parallels that of Benavie and Froyen. An increase in the return on a particular asset (L or S) in the bank's balance sheet results in an increase in the demand for that asset and a reduction in its demands for substitute assets. At the same time, the bank is encouraged to increase its use of liability funds. An increase in the price of a particular liability item (D, B, or F) encourages the bank to substitute into alternative liabilities and to reduce its demands for all assets. When the required reserve ratio is increased, there is a substitution effect which works in the same direction as an increase in the deposit rate, in that the bank reduces its demands for assets and increases its use of liabilities other than deposits. However, there is in addition an income effect following a rise in q, because the bank must raise additional funds via increases in all liability items in order to support a given level of asset holdings. This income effect works in the same direction as the substitution effect except in the case of deposit supply, which on net is affected ambiguously by the rise in q. This result, of course, runs counter to the popular view that reserve requirements represent a clear 'tax' on deposits.

2.3.2. Bank behavior in imperfect loan and deposit markets When local banking markets are imperfect, each bank faces the deposit asset demand and loan asset supply schedules of its customers, and deposit and loan rates become choice variables for the bank. Its profit function takes the form +.

rc= rzl2 ( rs, rL, to) + rsS + reqDd( rs, rL, to) -s"

+

--

+

"

+ G(X) -- rDDd( rs, rL, ~D) -- rBB-- r F F _C(E(

÷ rs,- rL, +rD),S,X,

Da( rs, rL,~D),B,F),

(lo)

where E . (rs, + -rL, +rv)= . hE(+

s-+ -rL, + . rs, -rL,'rD)+ f - E(rs, rD), and

D (rs, rL, ro)= hDd(rS, rL,~V)+fDd(rs, ra,~D). d

-

-

"~

The basic form of this model is very similar to that used in most microbanking studies, such as those by Klein (1971), Mingo and Wolkowitz (1977),

D.D. VanHoose, Monetary policy under alternative bank market structures

391

and VanLoo (1980). As in those papers, banks experience no internal deposit creation. Each bank is but one of many, and its power in local loan and deposit markets stems either from bank-customer relationships that act to create differentiation barriers or from actual geographical entry barriers, such as branching or chartering requirements. However, it is not a pure or collusive national monopoly/monopsony as might be the case in some of the European markets referred to by Aftalion and White, whose analysis does include consideration of the effects of redepositing on bank behavior. 7 This model differs from most 'monopoly-type' bank models by allowing for interdependence between the loan asset supply and deposit asset demand schedules of the bank's customers. Because most work in the banking literature rarely requires analysis beyond first order conditions, the assumption of independent loan supply and deposit demand functions generally is not a problem. However, derivation of the bank's asset demand and supply and rate-setting functions given interdependence of these schedules is intractible unless specific assumptions are imposed. A key r$/+ -assumption is that all cross-partial second derivatives of lZtrs, rL, +rM\ and Dd(rs: rL,'~D) are zero; i.e., other than 'own' rates of return enter only as shift parameters in the schedules. The optimization problem gives rise to a bordered Hessian matrix which has three terms which are ambiguous in sign. These terms are signed by appealing to a consideration of the quantity adjustments which would be anticipated to occur following changes in exogenous variables (e.g., rs or ra) in the absence of inter-relationships among decision variables. Finally, assumptions are made that yield sufficient conditions for profit maximization; these assumptions are of the familiar variety of 'direct effects outweigh indirect effects', s Profit is maximized subject to the bank's balance sheet constraint, +

--

+

I~(rs, rL, r D ) + S + X = ( 1 - q ) D d(rs, - - rL, + rD)+B+F.

(11)

Solution of the constrained optimization problem, given the assumptions outlined above, yields the following functional forms:

bsd :

x

bsd ( +

? rs, rF, rB, +rQ, q),

,s,

;t),

b B d = b r ~l~-(rs, l'+ + rF, rB, rQ,~) ' 7F

+ + + -rL = rL( rs, rF, rB, rQ, q),

rD=

rD( + rs, +rF, +rB, +rQ, q),

bFd=bFd(+-

rs, rF, +rB, -rQ, q).

(12)

. . . . or this reason, the analysis m this paper can be regarded as complementary to, but separate from, that of Aftalion and White. In addition, it would be a mistake to apply the conclusions of this paper to nationally concentrated, European-type banking systems, just as it would be an error to consider the conclusions of their paper applicable to a U.S.-type system of m a n y geographically separate banking markets. SThe specific assumptions and rationales for their use are detailed in the separate appendix.

392

D.D. VanHoose, Monetary policy under alternative bank market structures

Actually, it is impossible to determine mathematically the signs of the derivatives with respect to r s. This fact becomes clear by examination of the balance sheet constraint in (11). An increase in r s produces positive loan supply and negative deposit demand effects which tend to offset the 'ownrate' security holdings response and the corresponding balance-sheet adjustments which conventionally would be anticipated to occur. The signs on r s in the functions given in (12) indicate an assumption that the 'own-rate' effect of an increase in r s is dominant. Under this assumption, maintaining portfolio balance requires that the bank increase its loan rate (so as to counter the positive loan supply effect) and draw down its excess reserves. It raises its deposit rate in response to the negative deposit demand effect induced by the rise in r s as it simultaneously substitutes into alternative sources of funds, namely Federal Funds and borrowings from the Fed. For the cases of increases in either r r or rB, the signs of the partial derivatives follow unambiguously. An increase in rr leads to substitutions for discount window borrowings and for deposit funds via an increase in ro. With the higher cost of Federal Funds, the bank is encouraged, ceteris paribus, to reduce holdings of securities, excess reserves, and loans; loan asset holdings are reduced via an increase in r L. Analogous balance-sheet adjustments follow from an increase in r B. As was the case with rs, the interdependence of the loan supply and deposit demand schedules produces mathematically indeterminate effects on bank behavior following an increase in rQ. Once again, the indicated signs on the partial derivatives with respect to rQ in (12) can be justified by the assumption that 'own-rate' effects are dominant. A rise in rQ encourages the bank to raise its deposit rate to attract more reservable deposits as it simultaneously substitutes away from Federal Funds and Fed borrowings and utilizes the deposit funds to expand its asset portfolio by increasing its holdings of securities and excess reserves and lowering its loan rate to attract more loan assets. When the reserve ratio q is increased, there are two potential sets of behavioral responses which can occur. First, the bank may perceive that it has less deposit funds available net of the required level of reserves against deposits, which would act to provide an incentive to reduce asset holdings and substitute into discount window borrowings and Federal Funds on the liability side of its balance-sheet. If the bank also raises its deposit rate so as to retain the same net deposit base for supporting its-asset portfolio, a positive loan supply effect occurs for a given loan rate. On the asset side of the balance sheet, then, there would be upward pressure on the loan rate and a need for downward adjustments in holdings of securities and excess reserves. The above discussion describes a situation in which the income effect of a rise in q is dominant. However, there is a clear substitution effect which must

D.D. VanHoose, Monetary policy under alternative bank market structures

393

be considered. A rise in q means that, for a given deposit rate, the bank has a smaller net base of deposit funds available to support its asset portfolio, so that it incurs a higher cost for usable deposit funds than was the case prior to the increase in q. This fact could encourage the bank to reduce its deposit rate, producing a negative loan supply effect on the asset side of the balance sheet. The negative loan supply effect, in addition, provides an incentive to substitute for securities and excess reserves and to utilize less funds on the liability side of the balance-sheet. These income and substitution effects following from a rise in q are similar to those described in the case of perfect banking markets already discussed. In the case of imperfect competition, however, the interdependence of the loan supply and deposit demand schedules causes the completely indeterminate effects on bank behavior of a rise in q reported in (12). Unlike the cases of increases in rs and rQ, there is no clear rationale for signing the partial derivatives with respect to q, because there is no reason to assume that either the income effect or the substitution effect associated with a rise in q is likely to be dominant.

3. Monetary poficy with imperfect banking markets When local banking markets are imperfect, the following equilibrium conditions follow from the microeconomic derivations summarized in (3), (6), and (12): f

--

+

+

--

S s ( r s, rL, r o ) + S - -

hd

+

--

--

+

+

9

S (rs, rL, ro)-- b dS (rs, rr, rn, rQ, q ) - S C B = O ,

(13)

- r L : O,

(14)

rD( rs, rr, rB, ro,~t)--rD=O,

(15)

b --d-

(16)

EL ( + ,~ r s, +re, +rB, --rQ, q)

+

+

+

+

-

+

+

-

?

F ( rs, re, rn, re, q) = 0,

bRd(es,er,rB, rQ,q)-- bB~ (rs, + + rF, rB, ro, q) 9

?

9

4"

9

= S C B - had( rs, rL, rD) - - f A n ( rs, rL, ro) '

(17)

where S

= securities issued by the Treasury, held fixed throughout, S C B =securities held by the Federal Reserve or, alternatively, currency plus unborrowed reserves, and R = total bank reserves, with bRd = bxd + qD s.

394

D.D. VanHoose, Monetary policy under alternative bank market structures

Eq. (13) is the equilibrium condition in the market for government and firm securities, while (14) and (15) are the equilibrium conditions for prevailing levels of loan and deposit rates, which, although determined in individual, locally imperfect banking markets, must respond in the same direction to changes in exogenous variables. As stated by eq. (16), net demand for Federal Funds by the banking system must be zero in equilibrium. Finally, (17) requires that the market for unborrowed bank reserves be in equilibrium. As in the Benavie-Froyen model, this set of equations describes different types of models depending upon the operating procedure of the Federal Reserve, which can choose either to use the Federal Funds rate (rF) as its operating target or to a set a level of currency and unborrowed reserves ( S C B ) exogenously and allow rF to adjust freely. In either case, (17) can be eliminated via Walras' Law, as applied to (13), (16), and (17), since (14) and (15) imply that loan demand and supply and deposit demand and supply are identically equal, respectively, given that banking firms are behaving in imperfect markets. Deletion of (17) reduces the system for solution to (13) through (16). In this and the following section, the focus of analysis is placed on the equilibrium adjustments of r s and r L following a specific policy action. If both r s and r L are raised (lowered) as a result of a particular action, the implication is that a contractionary (expansionary) impulse is transmitted to the real sector of the, economy. If the effects of a policy instrument on one or both rates is ambiguous, the net real-sector impulse is taken to be ambiguous as well. In other words, it is assumed that, prior to the policy actions, an equilibrium relationship between rs and rr. and the marginal product of capital has been established. The latter is fixed in the short run, so that the initial effect of a policy action is to disturb this equilibrium via the effects on rs and r L. It may be of help to the reader to conceptualize this model as an examination of an L M surface in r s - r L - o u t p u t space. Comparative statics exercises are performed in order to indicate the direction of a shift in this surface, which may be upward, downward, or ambiguous in direction with respect to the two relevant interest rates. A particular policy action can have clearly effective impacts on real output only when the direction of the shift along a corresponding I S surface is unambiguously of the same direction with respect to both rs and rL. It should be kept in mind throughout that the purpose of the analysis is not to track the terminal effects of policy actions on the real sector. Such an attempt would require a more elaborate framework. Instead, the goal of the analysis is to compare and contrast the immediate impacts of policy actions under regimes characterized by alternative bank market structures. This form of analysis can best indicate the ways in which policy effects are likely to differ under the alternative regimes. Although the initial effects on r s and rr

D.D. VanHoose, Monetary policy under alternative bank market structures

395

are always of primary interest, the effects on r o and S C B or r e (dependng upon whether S C B or re is the endogenous variable) are reported as well to aid in explaining the results. 3.1. The Federal Funds rate as an operating target

When re is the Fed's operating target, (13) through (16)jointly determine rs, re, rD, and SCB. The policy instruments available to the Fed in this case are re, ra, ro, and q. An increase in the Federal Funds rate yields the following comparative statics results: Ors

OrL

OrD

~-~r> 0 '

0-~rr> 0 '

0-~rr> 0 '

OSCB <>0

Ore

(18) "

An increase in the targeted level of re has the conventional contractionary effects in an economy characterized by imperfect local banking markets. It is interesting to note, however, that t h e effect on S C B is not necessarily negative. The reason for this is straight-forward. The increase in rs, coupled with outward shifts in loan asset supply schedules and inward shifts of deposit asset demand schedules faced by banks in their local markets, acts to place upward pressure on r e. Therefore, a net increase in S C B may be necessary to keep re at its new setting. For the discount rate instrument, the following results are derived: ars

Ore.

0rB <0,

~--~n~0, ~-~rB~:0, 0r----~-->0.

Orb >~

OSCB

(19)

The last result in (19) is obtained by applying the correspondence principle; i.e., the assumption is made that the time rates of change in r s and S C B are increasing functions of an excess supply in the securities market and an excess demand in the Federal Funds market, respectively, while the time rates of change in rL and r D are increasing functions of negative divergences from their equilibrium levels. The first result in (19) corresponds to that obtained by Benavie and Froyen in their more aggregative perfect-market model: an increase in the discount rate under an re-oriented policy procedure reduces the rate of return on securities. As in their model, the increase in r B encourages banks to reduce their discount window borrowings, reduce holdings of securites and excess reserves, and increase Federal Funds borrowings. In addition, the initial effects on the loan and deposit rates set by banks in this imperfect-market model are positive. However, the increase in Federal Funds demand puts upward pressure on re, and the pegged level of re in this case can be maintained only by an increase in S C B sufficient to more than offset the initial upward pressure on r s. The reduction in rs then

396

D.D. VanHoose, Monetary policy under alternative bank market structures

serves to produce the ambiguous policy effects on r o and, more importantly, on re., so that the net real sector impact of the increase in r B is ambiguous under the re-targeting procedure. An increase in rQ yields the following comparative statics effects: Ors OrQ > O,

OrL OrQ X O,

Ore OrQ > O,

OSCB --Oro. ~ O.

(20)

Although the initial effect of the increase in rQ on r s is negative, following from an increased bank demand for securities, the unambiguously positive stimulus imparted to ro acts to produce a counteracting increase in the supply of securities by firms and a counteracting decrease in the demand for securities by households. On net, then, the security rate is increased. The rises in rs and ro together impart upward pressure on bank loan rates which acts to offset to some extent the downward movements which would otherwise occur following the increase in rQ. The net real-sector effect of the increase in rQ therefore is ambiguous. The reserve ratio q has ambiguous effects on both rs and rL; these ambiguities, of course, follow directly from the inability to determine behavioral responses on the microeconomic level of the analysis. 3.2. Currency and unborrowed reserves as an operating target

When SCB is the target variable in the financial sector, (13) through (16) jointly determine r s, rL, ro, and re. Available policy instruments are SCB, rB, r e , and q. In this case, no determinate results emerge unless the correspondence principle is invoked. If it is assumed that the time derivatives of r s and r e are increasing functions of an excess supply of securities and an excess demand for Federal Funds, respectively, while the time rates of change in rL and ro are increasing functions of negative deviations from their equilibrium levels, then the following sets of comparative statics results can be obtained. Recalling that real-sector effects of policy are transmitted through r s and r L, the comparative statics effects of an increase in the SCB target are given by (21): Ors

OSCB < O,

OrL

OSC-----B < O,

These results are entirely securities reduces rs, and deposit rates as well as the Under the SCB-oriented

OrD

OSC------~-< O,

OrF

OSC-----B < 0.

(21)

conventional. An increase in Fed purchases of the decline in rs acts to reduce local loan and equilibrium Federal Funds rate. policy procedure, ra also has the conventionally

D.D. VanHoose, Monetary policy under alternative bank market structures

397

recognized impacts: Ors

Or L

Or>0,

~-~rn>0,-~rB>0,

Or D

OrF

~-~rB>0.

(22)

The increased discount borrowing rate causes banks to reduce security holdings, placing upward pressure on r s. Banks raise the rates charged on loans and increase the rates paid on deposits. In addition, banks substitute for discount window borrowing by increasing their demands for Federal Funds, resulting in an increase in r v. When r e is increased, the comparative statics results are completely ambiguous: OrS

Or L >~

arQ~0,

O-~ra~O, ~-~rQ~:O,--~0

OrD >~

OrF Ore

•

(23)

When S C B is the targeted variable, it is no longer the case that Federal Funds are available at a constant cost, as was the case when r r was the variable targeted by the Fed. As a result, the movement in r o is no longer unambiguously positive, nor is the change in r s. Similarly, the effects of a rise in q are ambiguous as well, again because the reserve ratio produces ambiguous behavioral incentives for banks.

4. Monetary policy with perfectly competitive banking markets When banking markets are characterized by pure rate-taking behavior, the following set of equations describes full equilibrium in the financial sector: f S S ( r s , qrL,'rD) + s - - h a d (

-- bsd(

-rs, r L , rD)

"~S' rL, rD, rF, rB, ~Q, q) -- S C B = O,

hi2( + rs, -rL, + rD)

-}- f I_~( ~ S , - rL, +r D ) _ b I 2 (

b - - s "+

+

--

+

+

b

d +

+

+

-

+

-

_ 9

9

-

~

9

+

1) ( rs, rL, ro, rr,

b

r~, +ro,/.)9

rS, + r L, rD, rF, rB, + rQ, q) = O,

-- hDd( rs, rL, ~O) -- f Dd( r s, rL, + rD) = O,

F (rs, rL, rD, rF, rn, r Q , ~ ) = O ,

R°(rs,/.L, ro,/'/7,/'e,

(24) (25) (26) (27)

rQ, q) ?" -- b.-.a, + tr( + rs, + rL, + ro, + rF, rB, to. , q)

= S C B - hAd( rs, rL, rD)--

YAn(rs, rL, rD).

(28)

398

D.D. VanHoose, Monetary policy under alternative bank market structures

This set-up is essentially that of Benavie and Froyen extended by the addition of a separate market in bank credit (loans). The equilibrium conditions follow from the microeconomic derivations in (3), (6), and (9). The resulting framework is a typical Tobin-Brainard (1963) type of model. It is characterized by gross substitutability of assets, which is derived via the simple framework spelled out in section 2. More important, it is constructed on the traditional assumption of perfectly competitive banking markets. In this section, the effects of policy actions in this perfectly competitive banking system are derived and contrasted with those of the previous section. 4.1. The Federal Funds rate as an operating target

Again, Walras' Law can be invoked to reduce the solution system to (24) through (27), and when rF is the Fed's target variable these four equations jointly determine r s, rr., to, and SCB. The Fed's set of policy instruments is r F, rs, rQ, and q. In this case, the correspondence principle is utilized by assuming that the time derivatives of rs, rt., and ro are increasing functions of excess supplies in each respective asset market, while the time rate of change in S C B is an increasing function of the excess demand for Federal Funds borrowings. If the target level of rr is increased, the interest rate effects are as follows:

t~rs

drr.

~3ro

t3SCB

~-~rr<>0, ~-~rF>0, ~-~rr>0, Or----~O.

(29)

The first result in (29) is not at all conventional. In fact, the initial effects of an increase in r r are rises in rs, rr., and r o as banks reduce the size of their asset portfolios and substitute deposits and Fed discounts for Federal Funds borrowings. However, increases in these rates have feed-back effects in the Federal Funds market as supply responses in the security and loan markets occur, thereby causing banks to re-adjust their portfolios in the opposite direction from that of the initial effect of the rise in rr. This secondary effect, in turn, puts new upward pressure on rF as banks seek funds to augment their portfolios. The rises in r s and rr. also reduce deposit asset demand, reinforcing the upward pressure on r F as banks substitute into Federal Funds as deposit funds become less readily available. Maintaining the newly-set level for rr could then require that S C B be increased by enough to more than offset the initial increase in rs, hence the indeterminate effect on rs reported in (29). A comparison of the results in (29) to those in (18), which were derived in an imperfect bank markets/rF-targeting model, indicates an important instance in which bank market structure has impacts on a macroeconomic level. In the case of imperfect markets, the effect on S C B of an increase in r F

D.D. VanHoose, Monetary policy under alternative bank market structures

399

was also ambiguous; however, the potential downward effect on r s in that case was not sufficient to produce an indeterminate result. In contrast, the indeterminate effect of rF on S C B in a perfectly competitive banking system causes spill-over effects in the security market, resulting in an ambiguous real-sector policy impulse for rF. In a competitive regime, bank competitors do not have the market power to alter rates of return on assets in response to policy actions. Instead, all equilibrium adjustments in rates of return are viewed as external, market-determined forces by individual banks. These equilibrating forces are somewhat internalized to the banks themselves when local markets are imperfect. In a regime of imperfect local markets, banks can make offsetting adjustments to particular policy actions by changing the rates charged on loans and paid on deposits, thereby alleviating some of the upward pressure that otherwise would be placed on the targeted level of the Federal Funds rate. Therefore, it is less likely in a regime of monopolistic elements that the Fed will be forced to counter a rise in the security rate in order to target successfully the Federal Funds rate. In the case of an increase in the discount rate, the comparative statics results in this perfect markets/rr-targeting model are c3rs

c3rr.

dr D

0r---~<0,

a - ~ <>0,

~-~r<>0,_ Or-----~>0.

aSCB

(30)

These results correspond exactly to those of the imperfect-markets model given in (19). Again, the initial effects on r~. and r D are positive when r B is increased by the Fed. However, the rise in rL causes firms to reduce their supply of security assets while households and banks simultaneously increase their demands for securities. In the deposit market, the initial positive impact on r o leads to counteracting pressures as firms and households increase their demands for deposits. The increase in r B also encourages banks to reduce their borrowing with the Fed and substitute with Federal Funds borrowings. Each of these behavioral responses tends to place upward pressure on the targeted level of re. This upward pressure on r~ is countered by an increase in S C B sufficient to result in a net reduction in the equilibrium level of r s. This reduction in rs, in turn, acts to produce the indeterminate effects of rs on rL and to. An increase in the rate paid on required reserves produces the following results:

Ors

t~rL

arD

drQ <~0'

~-QrQ< 0 '

~-~e> 0 '

OSCB c~rQ

O.

(31)

In this case, r~. is unambiguously reduced as competitive banks increase their demands for loan assets. This stimulative real-sector effect is countered by the ambiguous impact on the security rate. The simultaneous fall in the loan

400

D.D. VanHoose, Monetary policy under alternative bank market structures

rate and rise in the deposit rate help produce this ambiguity, as does the fact that any downward pressure on rv following the rQ-induced fall in the demand for Federal Funds would need to be counteracted by a reduction in reserves by the Fed. It is interesting to compare the results in (31) to those of the case of imperfect markets and Federal Funds rate targeting reported in (20). In particular, it is notable that the existence of monopoly power in local loan markets creates the possibility that Ort./Ore may be positive, whereas this partial derivative is unambiguously negative in the case of perfectly competitive loan markets. On the other hand, the impact of rQ on the security rate is positive in the imperfect-markets case and ambiguous when markets are perfect, as discussed above. In any event, the net real-sector impacts of r e are once again indeterminate. A rise in q has an ambiguous effect on each endogenous variable in the perfectly competitive case. This result corresponds once again to that obtained in the case of imperfect markets. However, Ors~t?q is negative and OSCB/Oq is positive when the income effect is dominant in influencing banks' deposit supply behavior [i.e., D~ in (6) is positive, so that banks in this situation respond to an increase in q by increasing their supplies of deposits]; this would be a somewhat unconventional result. Of course, the net impact on the real sector of the economy is indeterminate in either case, because the equilibrium effect of a rise in q on rL cannot be determined.

4.2. Currency and unborrowed reserves as an operating target When SCB is the Fed's target variable in a regime of perfect banking markets, (24) through (27) together determine rs, r~, ro and rr. Once again, the correspondence principle is invoked to allow the derivation of determinate comparative static results. The time rates of change in rs, r~., and ro again are assumed to be positive functions of excess supplies in the three respective markets, with the time derivative of r r posited to be an increasing function of the excess demand for Federal Funds. As in the case of imperfect banking markets, the effects of an increase in SCB remain entirely conventional: Ors

OSC------~<0,

OrL

OSC-------~ <0,

OrD

OSC-----~<0,

OrF

c3SC------~
(32)

The real-sector impulse transmitted by the change is once again unambiguously stimulative. The effects of an increase in the discount rate under SCB targeting are also unchaged:

&s grB > O,

arL OrB > O,

Orb OrB > 0,

~rv > OrB 0.

(33)

D.D. VanHoose, Monetary policy under alternative bank market structures

401

As was the situation under imperfect banking markets, the real-sector effect of the increase in rB is contractionary. Also unchanged in a perfect-markets regime are the ambiguous effects of rQ and q. For rQ, the fact that the Fed no longer provides sufficient reserves to peg rr causes spill-over effects from the Federal Funds market which produce indeterminate effects on the endogenous variables in the system. In the case of an increase in q, similar ambiguous equilibrium effects emerge when SCB is held fixed by the Fed. However, if the income effect of q as an influence on bank deposit supply behavior is dominant, then drs/t3q and t3rL/dq are both positive. Although this result would correspond to the traditional contractionary effect associated with an increase in q, it does not necessarily follow, since there is a clear substitution effect on deposit supply. In general, then, the effect of an increase in q must be considered indeterminate.

5. Interpretations and conclusions The accompanying table 1 summarizes the short-run real-sector effects of policy actions as transmitted via interest rates on securities and loans. Two basic conclusions emerge from the theoretical results which have been derived and discussed in the previous sections. First, bank market structure can affect the types of equilibrium adjustments which follow specific policy actions, at least to the extent that different market structures produce alternative forms of bank behavior. Second, differences in bank market structure and behavior appear in this paper to have macroeconomic implications only when the Federal Funds rate is the operating target adopted by the Fed. Table 1 A comparison of the results. Policy instruments Bank market structure

Endogenous Under rr targeting interest rate rF re ro

Imperfect

rs

+

-

+

local

rL

+

?

markets

Net effect

+

Perfect

rs

banking markets

J.B.F.-- D

Under SCB targeting q

ra

rQ

q

?

+

7

.9

7

?

+

?

?

?

?

.9

+

7

?

?

-

7

.9

+

?

.9

rL

+

?

-

?

+

7

.9

Net effect

?

?

?

?

+

?

.9

SCB

402

D.D. VanHoose, Monetary policy under alternative bank market structures

The former conclusion, while not particularly surprising, does not seem to have been recognized in most of the preceding literature on monetary policy. Past discussions of bank market structure have focused on the microeconomic issue of bank performance, measured by such factors as profitability, credit availability, and deposit or loan rate levels in local markets. Macroeconomic policy implications have been largely ignored in formal analyses, except for the previously-cited work by Aftalion and White. The latter result has no evident counterpart in the literature. Perhaps the most surprising implication of the analysis is that the Federal Funds rate policy instrument does not necessarily produce conventional short-run effects in a competitive banking system, even though it can be used to bring about completely unambiguous effects when local loan and deposit markets are imperfect. The underlying reason for this result, as discussed in the last section, is that 'feed-back effects' via the Federal Funds market are more likely to produce indeterminate equilibrium security rate adjustments when markets are competitive. Under imperfect competition in local markets, banks can partially offset the effects of policy actions, reducing the likelihood that such feed-back effects will arise. As market behavior more closely approximates pure rate-taking on the part of banks, these feed-back effects become externalized forces which can place upward or downward pressure on the Federal Funds rate. Attempting to peg that rate can then potentially become a self-defeating policy for the Federal Reserve. It can be concluded that, in a very important sense, a regime of imperfect local banking markets is, from a monetary policy-maker's perspective, less complex and possibly preferable to one characterized by pure rate-taking behavior. The analysis conducted in this paper indicates that either a Federal Funds rate targeting procedure or a procedure designed to target the level of currency and unborrowed reserves is qualitatively effective in a banking system in which rate-setting behavior is widespread. However, only the latter procedure is clearly effective in a competitive banking system. Although the theoretical results do not indicate that Federal Funds rate targeting necessarily would produce ambiguous effects in actual practice, they do cast doubt upon the desirability of such a procedure. Of course, this conclusion provides additional support for the 1979 switch to a reserve-based policy on the part of the Fed. If banking markets actually are becoming more competitive via innovation and deregulation, a reserveoriented targeting procedure should be more likely to produce qualitatively predictable real-sector impulses, particularly as the banking system undergoes an evolution toward a more competitive regime. Additionally, the results indicate that the procedural change should make the discount rate a more effective short-run policy instrument under either form of bank market structure. Under Federal Funds rate targeting, the discount rate produces counter-intuitive security market effects which act to offset the contractionary

D.D. VanHoose, Monetary policy under alternative bank market structures

403

impact which would otherwise occur in the bank credit markets. By pegging the Federal Funds rate, the Fed actually acts to blunt the effects of this instrument of policy. The payment of interest on required reserves may be desirable on efficiency or welfare grounds, but the results summarized in table 1 imply that the interest rate paid on reserve holdings with the Fed is unlikely to be a useful instrument for macroeconomic policy. Another interesting implication is that an increase in this interest rate will clearly produce lower loan rates and higher deposit rates only when markets are competitive and when the Federal Funds rate is pegged by the Fed. When the level of currency and unborrowed reserves is the targeted variable in the financial sector, the freely-adjusting Federal Funds rate acts to produce spill-over effects in the loan and deposit markets in a competitive system which can counteract the loan and deposit rate movements which might otherwise occur.

Finally, the required reserve ratio is also likely to be a rather ineffective short-run policy instrument under either form of bank behavior and under either policy procedure. A change in this ratio produces both income and substitution effects which tend to work in opposite directions in their effects on equilibrium adjustments within the context of either form of bank market structure. Friedman (e.g., 1960) has long argued that reserve requirements are an inappropriate and largely ineffective policy tool; similarly, he has argued that any interest rate on required reserves should be tied to some other endogenous rate rather than being subject to direct control by policy-makers. The results of the analysis originally conducted by Benavie and Froyen and extended in this paper tend to support his contentions on these points.

References Aftalion, Florin and Lawrence White, 1977, A study of a monetary system with a pegged discount rate under different market structures, Journal of Banking and Finance 1, 349-371. Alhadeff, David, 1974, Barriers to bank entry, Southern Economic Journal 40, 589-603. Baltensperger, Ernst, 1980, Alternative approaches to the theory of the banking firm, Journal of Monetary Economics 6, 1-37. Benavie, Arthur and Richard, Froyen, 1982, Monetary policy in a model with a Federal Funds market: Fixed versus flexible deposit rates, Southern Economic Journal 48, 932-949. Benston, George, 1973 The optimal banking structure: Theory and evidence, Journal of Bank Research 3, 220-237. Bryant, John, 1981, Bank collapse and depression, Journal of Money, Credit and Banking 13, 454--464. Buser, Stephen, Andrew Chen and Edward Kane, 1981, Federal deposit insurance, regulatory policy, and optimal bank capital, Journal of Finance 36, 51-60. Friedman, Milton, 1960, A program for monetary stability (Fordham University Press, New York). Heggestad, Arnold and Stephen Rhoades, 1976, Concentration and firm stability in commercial banking, Review of Economics and Statistics 58, 443-452.

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D.D. VanHoose, Monetary policy under alternative bank market structures

Heggestad, Arnold, 1979, Market structure, competition, and performance in financial industries: A survey of banking studies, in: Franklin Edwards, ed., Issues in financial regulation (McGraw-Hill, New York) 449-490. Hester, Donald, 1981, Innovations and monetary control, Brookings Papers on Economic Activity 1, 141-189. Hodgman, Donald, 1963, Commercial bank loan and investment policy (Bureau of Economics and Business Research, Champaign, IL). Kane, Edward, 1981, Accelerating inflation, technological innovation, and the decreasing effectiveness of banking regulation, Journal of Finance 36, 355-368. Kareken, John and Nell Wallace, 1978, Deposit insurance and bank regulation: A partialequilibrium exposition, Journal of Business 51, 413-438. Klein, Michael, 1971, A theory of the banking firm, Journal of Money, Credit and Banking 3, 205-218. Mingo, John and Benjamin Wolkowitz, 1977, The effects of regulation on bank balance sheet decisions, Journal of Finance 32, 1605-1616. Niehans, Jurg, 1978, The theory of money (Johns Hopkins University Press, Baltimore, MD). Scherer, Frederic, 1980, Industrial market structure and economic performance, 2nd edition (Rand McNally, Chicago, IL). Tobin, James and William Brainard, 1963, Financial intermediaries and the effectiveness of monetary controls, American Economic Review 53, 383-400. VanLoo, Peter, 1980, On the microeconomic foundations of bank behavior in macroeconomic models, De Economist 128, 474-496. Wood, John, 1975, Commercial bank loan and investment behavior (Wiley, London).