Essays on banking

This dissertation contains three essays which look at the role of price competition in banking. The method of investigation is a theoretical one. The first two essays examine the relative efficiency of relationship banking and price banking. The third essay discusses the determination of bank interest margin. Conventional wisdom suggests that increased interbank competition should improve social welfare and thus price banking should dominate relationship banking. Essay one shows that the opposite result may occur when the product market is imperfect and the lending instruments are loan commitments. Under relationship banking both banks and borrowers have bargaining power. The borrowers have substantial bargaining power when the costs of switching banks are small. In this case, it pays the banks to charge interest rates below the competitive rates in order to keep their customers. The interest losses are compensated for by higher commitment fees paid upfront by the borrowers. Since interest costs are lower under relationship banking than under price banking, borrowers produce more and output price declines. Social welfare thus unambiguously increases. Essay two goes on to examine the relative efficiency of relationship banking and price banking under the asset substitution problem. The bank-customer relationship is assumed to provide a credible commitment for a borrower to refrain from transacting with other banks. The outcome under relation-ship banking is second-best since underinvestment results in solving the asset substitution problem. The multilateral credit transactions permitted by price banking impose negative externalities to existing loans by inducing the borrower to substitute riskier project. More underinvestment is needed to resolve the dual incentive problem and equilibrium results in reduced welfare for borrowers. Essay three tackles the determination of bank interest mar-gins using a simple production-based model of risk-neutral banks which face (i) loan default risk, (ii) interest rate risk, (iii) capital regulation, and (iv) deposit insurance. The optimal bank interest margin is shown to be increasing with the variability of the short-term money market rate, but decreasing with either a stiffer capital requirement or an increase in the flat-rate deposit insurance premium.Business, Sauder School ofGraduat