Whether or not banks are engaged in ex ante monitoring of customers may have important consequences for the whole economy. We approach this question via a model in which banks can invest in either information acquisition or market power (product differentiation). The two alternatives generate different predictions, which are tested using panel data on Finnish local banks. We find evidence that banks’ investments in branch networks and human capital (personnel) contribute
to information acquisition but not to market power. We also find that managing customers’ money transactions enhances banks ability to control their lending risks.

Whether banks are engaged in one or the other activity may have significant consequences outside the industry itself: a large literature suggests that banks’ (in)ability to solve informational problems affects the severity of the effects of macro-level shocks (eg Greenwald and Stiglitz 1993, Holmstrom and Tirole 1997). It is therefore critical to know whether, and through what mechanisms, banks collect and process information. There exists indirect evidence that banks are indeed in the business of acquiring information.3 The main purpose of this paper is to provide a test of the PHDQV by which banks acquire information. A common feature of information acquisition and market power is that they are both likely to require fixed investments (but see Petersen and Rajan 1994 and section 4 below). Notwithstanding recent investments in electronic banking, commercial banks' most obvious of such investments are those in branch networks and employees' human capital. We argue that investments in branches and human capital can serve two basic purposes: information acquisition and/or market power. Information acquisition requires personnel who are able to collect and analyze information, and investments in human capital increase these abilities.

After presenting the two theoretical models, we build an econometric model that encompasses both and test the models’ predictions using data from Finnish cooperative banks. These banks are small local banks that operate in geographically distinct, non-overlapping markets. They share several common features like ownership form and a quasi-central bank. As a group, they have by far the largest branch network, suggesting that they have made fixed investments. Although these banks share many features and institutions, they operate independently.

The Data and Market Environment

Currently, partly as a result of the severe economic crisis in Finland in the early 1990s, the Finnish banking market is dominated by a few banks/banking groups, one of which consists of over 250 local cooperative banks. Our sample covers almost all of these banks. The other traditional group of local banks, the savings banks, were the most prominent victim of the banking crisis and have been dramatically reduced in size as a consequence of a) a large merger between them and b) a splitting of the merged bank between the remaining banking groups in 1993. As a result of mergers, the three main banking groups in Finland consist of the group of cooperative banks, which we focus on here, and two commercial banks operating on the national level and having a nationwide branch network.

Several studies (eg Koskenkylä and Vesala 1994, Nyberg and Vihriälä 1994, Davis 1995) describe the events before and during the crisis, so we will offer only a synopsis here. The volume of lending grew very rapidly, at times by over 30% p.a. in the late 1980s. The growth was partly due to financial market liberalization that took place in the mid-1980s and partly due to an economic boom and lax monetary policy. The boom ended in a collapse of asset values, including real estate, which was a prime source of collateral, and the economy shrank by 8% in 1992 - 1994. Since then, the economy has been growing. The government bailout of banks has officially been estimated to cost approximately FIM 50 billion. Importantly for us, not a single bank was allowed to fail; hence sample selection is not an important issue.13 Nonetheless, the crisis may affect our results and so we check the robustness of our empirical results in this respect.

A comparison of the nationwide branch networks of different banking groups (see table 1) reveals that as a group the cooperative banks have by far the largest branch network.14 It is clearly larger than that of the other group of local banks, the savings banks. The size of the branch network of commercial bank Merita is roughly two thirds or less then that of the cooperative banks. This supports our implicit assumption that these are banks that have made (larger) fixed investments

Author: Ari Hyytinen,Otto Toivanen , Research Discussion Papers, Bank of Finland

Source: http://www.suomenpankki.fi/en/julkaisut/tutkimukset/keskustelualoitteet/Documents/0009.pdf