Relationships, Competition, and the Structure of Investment Banking Markets
AbstractPrevious studies have acknowledged the tradeoff between relationships and competition in financial intermediation. In this paper, we explore the structural determinants of this tradeoff in the investment banking market, by deriving it from the underlying relationship technology. In the model, each of several banks incurs a sunk cost to establish a relationship with the same firm; all compete for doing its deals. Alternatively, the firm can do deals with other banks on an arm’s-length basis. We study the role of a self-enforcing norm that restrains price undercutting on the incentives to make relationship-specific investments. We find that banks establish relationships even without local or aggregate monopoly power. Moreover, relationship banks make profits despite a competitive fringe of arm’s-length banks. Finally, a dual market structure emerges in equilibrium - a small number of relationship banks serve firms that make large and frequent deals; a competitive arm’s-length segment serves firms that make small and infrequent deals; and, competitive conditions in the fringe segment do not affect the relationship segment. In this way, we reconcile the coexistence of competitive and seemingly collusive features of this industry, which have been noted by many observers. We apply our framework to provide a logic for antitrust analysis of the industry, to examine the consequences of global competition and discuss the effect of the Internet on bank-firm relationships.
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Bibliographic InfoPaper provided by Centro de Economía Aplicada, Universidad de Chile in its series Documentos de Trabajo with number 96.
Date of creation: 2000
Date of revision:
This paper has been announced in the following NEP Reports:
- NEP-ALL-2002-05-03 (All new papers)
- NEP-ENT-2002-05-03 (Entrepreneurship)
- NEP-NET-2002-05-03 (Network Economics)
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