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Number 93-04, January 29, 1993

Competitive Forces and Profit
Persistence in Banking
Like virtually all industries, banking is subject to
regulations that encourage competition. Forexample, banks cannot merge if doing so would
tend to create monopolies in banking markets.
However, unlike most other industries, banks are
subject to a wide variety of regulations designed
to protect the stability of the financial system and
meet other objectives. As an unintended side
effect, these regulations may dampen the forces
of competition. For example, chartering requirements and branching restrictions may impede
entry by new competitors and expansion by
existing banks. Entry by nonbank financial or
nonfinancial firms is limited due to legal restrictions on the activities in which banking firms
may engage.
If the opposing influences of bank regulation
have the net effect of weakening competitive
forces, bank profits should reflect that. When
bank profits differ from the "normal" competitive
level, adjustment back to that level should take
longer in banking than in other industries-that
is, profits should be more persistent in banking.
In this Letter, financial and stock price data are
used to estimate the adjustment speed in the
banking industry and, hence,.to examine the
degree to which abnormal bank profits tend to
persist in the face of market forces. The results
indicate that above-normal profits in banking are
fairly long-lived compared to other industries.

Creation and destruction
of above-normal profits
In theory, firms in competitive markets should
earn normal long-run profits that provide investors with returns identical to those on comparable investments. A bank in a competitive market
can earn above-normal profits for some period
only by having a product that is perceived as superior in some dimension-successful product
differentiation-or by producing the same products as competitors but at lower cost-successful
cost leadership. Meaningful cost and product differentials might arise through luck; for example,
a bank might happen to be located in a region

that experiences a relative decline in labor costs.
Or product and cost differences might be created
intentionally, th~ough new products and services
whose value exceeds their cost to the bank, or
innovative ideas for cutting costs without unduly
sacrificing current levels of service and product
quality. Either good fortune or good ideas can
create a "competitive advantage" for a bank,
leading to an increase in profits without a corresponding increase in risk.
But if competitive forces are allowed to operate,
such an advantage cannot last indefinitely. Competitors will move into a newly profitable market
segment-either a product market or a geographic market-as soon as they can, or will
imitate successful new practices. Once competitors catch up, the competitive advantage is
erased and the bank once again earns only normal profits. Persistent above-normal profits in the
face of these market-based adjustments depends
in large part on structural characteristics of the
markets involved and on the conduct of the
players in those markets. The speed of adjustment is an indicator of how competitive the
banking industry is; information on bank stock
prices can be used to measure that adjustment

The effect of profitability on stock prices
Bank share prices generally reflect expected
future profits, with heavier weight given to nearterm profitability, but with significant weight also
given to long-run profits. In financial terms, the
price of a stock reflects the present discounted
value of expected future profits. Thus for banks
with publicly traded stock, higher profits from a
competitive advantage translate into higher share
prices. As a very broad generalization, if a bank
always earns normal profits, its stock price is
equal to the accounting book value per share.
Higher profits tend to push the market value
above book value.
The relationship between future profits and a
bank's current stock price implies that not only

the current level, but also the longevity of any
above-normal profits is likely to have an important influence on bank stock prices. The longer
the above-normal profits are expected to persist,
the higher the current market value of the stock
will be relative to book value. The relationship
between bank stock values and the degree of
profit persistence can yield insight into stock
market investors' implicit beliefs about the rate
of adjustment of profits.

companies (all referred to here as "banks" for
convenience). Each point represents one bank.
The vertical axis shows the market-to-book ratio
as of the end of June 1991. The horizontal axis
measures the profit spread for each bank, with
profits measured over the year ending in June of
1991. Banks in the right half of Chart 1 earned
more than the normal return, while those on the
left earned less than they should have for the
level of risk taken.

Chart 1: Effect of Profitability on Stock Value
Market/Book Ratio


An initial view of the relationship
A necessary first step in analyzing profit persistence is to define what is meantby "profits"
and what is meant by "normal" profits. Profits
can be measured by the return on equity (ROE),
which is net income divided by the book value
of the bank's stockholder equity. A normal level
for the profit rate could be defined using any of
several approaches (the results are relatively
insensitive to the method used to establish the
normal level). A widely used model from finance,
the Capital Asset Pricing Model (CAPM), was
adopted for this analysis. The CAPM uses stock



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of return, taking into account risk and the general
level of interest rates. The difference between a
bank's actual ROE and the estimated normal return from the CAPM is a measure of the extent to
which profits differ from what should be expected
given the level of risk taken by the bank. This
abnormal profit differential can be termed the
"profit spread:'
A simple examination of the relationship between stock values and past profit spreads can
reveal the existence of bank profit persistence.
Expectations of positive profit spreads from competitive advantages should increase bank share
prices. Negative spreads from below-normal
profits-arising from bad luck or bad decisions
-should reduce stock prices. The more persistent the spreads are, the more the stock prices
will be raised or depressed relative to book
value. But only expected future profits have this
effect; if past profit spreads are systematically related to current market-to-book ratios, the market
must believe that bank profits are persistent, with
above-normal profits in the recent past signaling
the likely continuation of those spreads into the
Chart 1 illustrates the relationship between past
profit spreads and bank market-to-book ratios,
for a sample of 126 banks and bank holding

The chart indicates that, as a general rule, firms
with higher recent spreads have higher current
stock values. Moreover, those with above-normal
past profits tend to have market stock prices
above book value, while the opposite is true for
those with low past profits. The positive relationship suggests that the market takes high profits
from the immediate past as an indication of high
future profits, and low past profits as an indication of low future profits-that is, profits are persistent. However, more information is needed to
determine how great that persistence is.

Quantifying the effects
To look more closely at profit persistence in
banking, and to compare it to other industries, a
theoretical model was developed describing the
linkage between current and future profitability
and the market-to-book ratio. The model takes
into account the level of interest rates, growth
rates of banks, and differences in risk across
banks. The unique aspect of the model is that it
also incorporates market expectations of profit
spread decay over time. The theoretical model
was then translated into a statistical model and
applied to the same sample of banks used in
Chart 1, to examine the empirical relationship
between stock prices and profitability, and
ultimately to decipher stock market investors'
implicit beliefs about the rate of profit decay.

One significant problem was ignored above to
simplify the exposition: Reported accounting
profits may not accurately reflect banks' true
profitability. A variety of well-known peculiarities
of accounting practice might lead to accounting
profits being imprecise and biased as measures
of true economic profitability. Investors in the
market probably use accounting information, but
also filter the reported numbers to determine a
"true" (higher or lower) level of profits. These
investor opinions are then reflected in the market
price of bank shares. The statistical analysis took
this complication into account. (Details are available from the author.)

broken line) producing an initial spread of 10 percentage points either way. For both positive and
negative differences, the profit spread adjusts
back toward zero (that is, a position of normal
profitability) over time, but much more rapidly
from below than from above.

Chart 2: Profit Adjustment Paths

10% .



The statistical results showed that advilntages in
banking are fairly long lasting. The adjustment
speed based on the 1991 sample data is 4.4 percent per year for banks with above-normal profits;
that is, 4.4 percent of any positive spread between actual profits and the normal level should
disappear each year, all else equal. Comparable
evidence for other industries is scarce, but suggests that profit spreads disappear more quickly
for other kinds of firms: Other studies have found
rates ranging from 30 percent to 70 percent for
firms outside of banking.
Interestingly, while above-normal profits last a
long time, below-normal profits vanish much
more quickly; the estimated speed of adjustment
for negative profit spreads was 23.6 percent per
year. (Statistically, the adjustment speeds for high
and low profit banks are significantly different,
and both rates are significantly greater than zero
and less than one.) It seems reasonable that negative spreads should be less persistent, since the
banks that have the best information about the
existence and sources of the losses-the afflicted
banks themselves-are also those in the best
position to act on that information. In contrast,
positive spreads are reduced only when other
banks notice a competitor with a spread-creating
advantage, analyze its sources, and act to copy
or eliminate the advantage; in many cases, acquiring the needed information may be expensive and difficult for the other banks.
Chart 2 illustrates the difference in adjustment
between positive and negative spreads. The chart
shows the time path of the profit spreads implied
by the model for a hypothetical bank that begins
with normal profits, then develops an advantage
(the upper, solid line) or disadvantage (the lower,


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Profit Spread

An examination of the relationship between bank
profitability and bank share prices shows that
once a bank's economic profits rise above or fall
below a normal level, the profit spread persists
for some time. However. orofits do eventuallv return to normal. The fact'that high profits are ~ot
infinitely persistent is itself an important point.
Despite the fact that banking is a heavily regulated industry, market forces operate to drive
high (and low) profits back toward normal levels.
Persistent profits have ambiguous implications for
policy. In a sense, above-normal profits mean
that bank customers are paying too much. They
would be better off obtaining banking products
or services at prices closer to cost, with banks
earning only normal rates of profit. However, the
prospect of persistent high profits may encourage
innovation that benefits bank customers, in much
the same way that patent protection does in other
industries. Moreover, some of the slow adjustment of profits probably results from regulation;
the damage from weakened competitive forces
must be weighed against the benefits, such as
safety and soundness, that banking regulations

Mark E. Levonian
Research Officer

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor or to the author..•. Free copies of Federal Reserve publications can be
obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120.
Phone (415) 974-2246, Fax (415) 974-3341.




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Index to Recent Issues of FRBSF Weekly Letter





Low Inflation and Central Bank Independence
First Quarter Results: Good News, Bad News
Are Big U.S. Banks Big Enough?
What's Happening to Southern California?
Money, Credit, and M2
Pegging, Floating, and Price Stability: Lessons from Taiwan
Budget Rules and Monetary Union in Europe
The Slow Recovery
Ejido Reform and the NAFTA
The Dollar: Short-Run Volatility and Long-Run Adjustment
The European Currency Crisis
Southern California Banking Blues
Would a New Monetary Aggregate Improve Policy?
Interest Rate Risk and Bank Capital Standards
A Note of Caution on Early Bank Closure
Where's the Recovery?
Diamonds and Water: A Paradox Revisited
Sluggish Money Growth: Japan's Recent Experience
Labor Market Structure and Monetary Policy
An Alternative Strategy for Monetary Policy
The Recession, the Recovery, and the Productivity Slowdown
U.S. Banking Turnaround


Cromwell /Tren holme

The FRBSF Weekly Letter appears on an abbreviated schedule in june, july, August, and December.