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For release upon delivery
Thursday, June 26. 1975
2:00 p.m. PUT; 5:00 p.m. EDT




BANK HOLDING COMPANIES
A N D FINANCIAL STABILITY
Paper presented by
Robert C. Holland, Member
Board of Governors of the Federal Reserve System
before the
Fiftieth Annual Conference of the
Western Economic Association
San Diego, California

June 26, 1975

The financial experiences of the last two
years impel a careful and wide-ranging review of the
stability of our major types of financial institutions.
That review ought to be followed by actions to redress
weaknesses or proclivities that, upon analysis, are
judged to contribute an undesirable degree of instability
within the financial system.
I can report that we in the central bank are
deeply involved in such a review.

A number of our

colleagues in Government, both here and abroad, are
similarly engaged.

I know many bank managements who

are devoting a great deal of time to thinking through
the implications of these events for their own
institutions.
I devoutly hope that the fraternity of academic
economists will also be a major contributor to the stream
of reappraisals of financial stability.

Your comparative

advantage, of course, is your capacity for greater
I want to particularly acknowledge the assistance of
Stephen A. Rhoades, Economist in the Board's Division
of Research and Statistics, in the preparation of this
paper. Except where explicitly indicated otherwise,
the positions herein expressed are my personal views
and should not be construed as official positions of
the Board of Governors of the Federal Reserve System.




- 2 objectivity and abstraction than we practitioners
can claim.

If you can exploit that comparative

advantage effectively in this sensitive area, I and
many people like me will be very much in your debt.
From my more parochial vantage point, I
would like to focus attention this afternoon on the
contributions to financial stability, or instability,
that I perceive in the bank holding company movement.
That movement has waxed powerful enough in recent
years to make it one of the central elements in our
financial system.

By December 31, 1970, bank holding

companies controlled 2,241 commercial banks with
deposits of $253 billion -- 52.6 per cent of all
U.S. commercial bank deposits.

By the end of 1974,

bank holding companies controlled 3,462 commercial
banks with $509 billion in deposits, accounting for
68.1 per cent of commercial bank deposits.

Acquisi­

tions of going concerns which have long been regarded
as a major vehicle for growth in the theory of the
firm, have increased substantially.




In 1970, bank

- 3 holding companies accounted for slightly less than
50 per cent of all acquisitions of banks, whether by
purchase by a bank holding company or merger into
another bank.

By 1973, this figure rose to over

73 per cent.
Expansion of bank holding companies into
nonbank activities in recent years has also been
impressive.

The number of acquisitions of nonbank

firms by bank holding companies rose from six during
1970 to 827 and 806 in 1973 and 1974 respectively.
De novo entry into nonbank activities has also been
substantial, with the number of such entries rising
from 71 during 1971 to 542 during 1974.

A n important

contributor to these large acquisition numbers is the
practice by many finance companies and other subsidiaries
of separately incorporating offices in different legal
jurisdictions.

When such clusters of "office corporations"

are netted out, however, the overall data still show the
existence of 531 bank holding companies controlling 3,632
nonbank companies as of December 1970 and 721 bank holding
companies with 4,812 nonbank companies by December 1973.




- 4 II.
These bank holding company dimensions raise two
particular questions of stability in my mind.

The first

concerns the possibility of an undesirable interruption
in the availability of financial services, such as can
happen during periods of tight money.
Most such interruptions at individual firms are
primarily the product of overaggressive management —
management making decisions which exceed the firm's
capacity to produce what is promised.

While instances

of overaggressive management have appeared in banking
in recent years, it is worth pointing out that such
behavior is not a necessary result of the bank holding
company form of organization.

The bank holding company

is simply a convenient channel through which aggressive
management behavior can express itself.

As a general

proposition, the bank holding company format can be
held responsible for no more than inviting some over­
aggressive management behavior in banking because of
the added scope for maneuver which it afforded.




- 5 Virtually all banks engaged in active financing
of a substantial part of the nation's economic activity
showed some deterioration in conventional "soundness"
measures during the last few years, whether or not they
were in a bank holding company.

The equity-asset ratio

for large holding company banks, however, appears to be
lower on average than that for large independent b a n k s .
A multi-variate analysis by Board staff members has
found evidence that among the 500 largest commercial
banks (1) bank holding company banks tend to have a
significantly lower capital-assets ratio than inde­
pendent banks, and also (2) the capital positions of
banks acquired by bank holding companies tend to
decline relatively subsequent to their affiliation.

1/

For whatever reasons, bank holding companies appear
inclined to increase the leverage of their bank
subsidiaries.

If Heggestad, Arnold A. and Mingo, John J., "Capital
Management by Holding Company Banks," Journal of Business,
forthcoming. Incidentally, differences in bank size were
accounted for in this study, and the data indicated that
the above-cited differences are not simply due to bank
size.




- 6 -

A more selective way to judge the contribution
of bank holding companies to financial stability is to
look at the character of their acquisitions.

The

information that I can report on this score is more
qualitative and judgmental, and is confined to domestic
affiliations, but I believe it is nonetheless useful.
Turning first to banks that have been acquired
by multi-bank holding companies, there have been a
small number of seriously weak banks in various parts
of the country that have been absorbed by bank holding
companies in recent years.

In every case I know, the

weak bank was subsequently strengthened -- at least a
little -- and such improvement is a clear and positive
contribution to financial stability.

The number of

such rescues to the credit of bank holding companies
would be larger, I believe, if appropriate legislation
were adopted to liberalize some current statutory
2/
constraints on such efforts.“

2_/ The Board of Governors has recently proposed
specific legislation to further this objective (S. 890
and H.R. 4008). One proposed provision would waive the
present statutory 30-day delay between Board approval of
a holding company acquisition and its consummation by the
applicant; the second provision would allow a bank holding
company to acquire a large failing bank in another state,
if no desirable alternative buyer could be found.




- 7 More typically, however, banks acquired by
bank holding companies had prior records of relatively
conservative management, and their post-acquisition
reports are more likely than not to show increased
loans to their communities.

Judged narrowly, such a

change has to be scored as an increase in the potential
instability of the particular subsidiary bank.

A case

can often be made, however, that the earlier management
had been overly conservative, and that the holding
company, because of its greater size and geographic
diversification, is better equipped to handle higher
loan r a t i o s .
With respect to acquisitions of nonbank firms
by bank holding companies, a rather different story
emerges.

Generally, the nonbank firms acquired by bank

holding companies in recent years have been smaller and
3
weaker financially than the acquiring organization.— /

3/ At least partly, this may be a result of the
demonstrated disinclination of the Board to allow the
largest bank holding companies to acquire the largest
firms in any bank-related industry.




- 8 -

Thus, in the first instance, affiliation with the
more powerful organization strengthens the position
of the nonbank firm.

Oftentimes such strengthening

is manifest in such concrete ways as reduced interest
rates on sales of its debt obligations or loans from
outside institutions.

Improved access to funds by the

new affiliate also has the potential for financing
subsequent more rapid growth and less fluctuating
volume relative to the affiliate's past performance
or to the record of independent competitors in its
industry.
These changes are of sizable import for the
financial system, since in several key nonbank
financial lines the percentage of the industry's
total receivables held in bank holding company
organizations has become substantial.

The table below

presents estimates of how far that penetration has
proceeded in the consumer and sales finance industry,
mortgage banking, factoring, and lease financing.




- 9

-

These are all lines of activity in which many
independent firms have experienced sharp cyclical
ups and downs in their ability to finance customer
demands.

At least for such firms, the protective

wing of a parent bank holding company has usually
brought a greater measure of financial stability.
Table 2
Estimated Shares of Industry Receivables
Held by Bank Holding Companies
December 1974

Industry
Consumer and Sales Finance
(86 largest noncaptives)
Consumer and Sales Finance
(L05 largest, including captives)

Share Held by Bank
Holding Companies
and Nonbank
Subsidiaries

221
97o

Mortgage Banking
(100 largest measured by volume
serviced)

32%

Factoring (30 largest)

507,

Leasing (estimate)

107o




Source:

Board of Governors of the Federal Reserve
System

- 10 On the other hand, it is impossible to avoid
the logical conclusion that absorbing these weaker
nonbank affiliates has placed a greater burden on the
resources of the parent holding company, and also on
its lead bank or banks.

This is all the more true

because reports to date suggest that bank holding
companies may tend to leverage their nonbank affiliates
more than the independent competitors of such affiliates.
Such greater leveraging underlines the reliance upon the
strength of the parent company and lead subsidiary bank(s)
to achieve and maintain adequate market acceptance.
Presumably it is an acceptable assertion that
banks on average are less risky enterprises than their
nonbank affiliates.

Nonetheless, since the latest wave

of nonbank acquisitions began around 1969, I know of
only a handful of cases in which nonbank affiliates'
performance was so poor as to seriously destabilize
the parent holding company or its lead bank.

The

problems of a few affiliate mortgage companies and
bank- and bank holding company-sponsored real estate
investment trusts fall into this category.




- 11 In the most extreme case, that of the Beverly Hills
Bancorp, analogous difficulties were instrumental in
bringing down the bank, but in other cases to date
the damage has been more limited.
The passage of more time, of course, could
bring more problems to the surface.

On the other

hand, the past year was surely a time of unusual
financial stress.

Managements have generally become

more conservative, and so have creditors of bank
holding companies.

Future years may be less turbulent

and provide opportunity for more settled operations
with less depressed net earnings.
In trying to judge the degree of instability
injected by nonbank affiliates, it is important to
keep in mind what a small share of total bank holding
company assets they presently represent.

At last

report (1973), balance sheet assets of nonbank affiliates
accounted for only 3 per cent of the total assets of
69 of the largest bank holding companies.

Extra risks

of those dimensions are not likely to constitute a




- 12 threat of any major consequence to the banking system
as a whole, even though the viability of an individual
organization might be prejudiced.
While such industry dimensions are still
relatively modest, however, there are certain areas
of doubt or uncertainty which might well be clarified
in the interest of promoting financial stability.

One

involves possible differences of view as to the extent
to which bank and bank holding company resources will
in fact be drawn upon to pay the liabilities of any
nonbank affiliate.

The fact is that current law and

regulation limit the ways in which bank resources can
be tapped to meet problems that afflict affiliates.
Business considerations, however, typically impel a
bank holding company management to do whatever it
responsibly can to honor the obligations of its
affiliates.
Occasionally, among the interested groups
dealing with a bank affiliate —

its creditors, its

customers, and its parent's shareholders, directors,
depositors and regulators -- representatives of one




- 13 group will voice a stronger or weaker expectation
than another as to parent and lead bank support for
the nonbank affiliate in time of need.

It will be

important for the future of the industry for such
views to be homogenized.

Both holding company

managements and their regulators need to work
assiduously at this task.
A second area in which clarification would be
timely deals with "double leveraging."

This phenomenon

can take place in a variety of ways, but is thought of
most simply as a bank holding company borrowing money
and investing it in equity securities in its key bank
affiliates.
Within judicious limits, this kind of financing
can have significant tax advantages for the holding
company.

That double leveraging is often practiced

is indicated by the fact that the 25 largest bank
holding companies combined invested $417 million in
new equity of their subsidiary banks in 1972 and $371
million in 1973.— ^

These equity investments in subsidiary

4/ Acquisitions of banks and acquisitions of existing
shares in partially-owned banks are excluded.




- 14 banks substantially exceeded the net new equity issued
by the parent bank holding companies.

Parent company

issues totalled $140 million and $116 million in 1972
5/
and 1973 respectively.
That double leveraging has thus far been
judiciously practiced is suggested by the fact that,
for the 25 largest bank holding companies as of 1973,
the total of their equity investments in all bank and
nonbank affiliates was only 8 per cent larger than
the recorded shareholders1 equity in their parent
holding companies.

Reassuring though this experience

may appear to date, market questions as to what might
be safe limits for "double leveraging" suggest the
wisdom of developing a realistic consensus on this
point as well, underscored by supervisory or regulatory
action if need be.

5/ Only $58 million of that $256 million of
parent company equity issues in 1972-73 was raised
by sales in the public market; the other $198 million
of equity was obtained through conversion of existing
debt and stock option plans. Shares issued in acqui­
sitions are excluded from these figures.




- 15 III.
Thus far in my remarks I have concentrated on
considerations of financial stability in the most
conventional sense of that term.

In this section of

the paper I should like to turn to a second and less
desirable dimension of financial stability —

namely,

the local market stability that can result from a
less than vigorously competitive group of sellers of
financial services.
That kind of market stability, with sticky
prices, little service innovation, and tacitly
uncontested market shares, epitomizes much of what
economists count on competition to dispel.

In general,

it is regarded as in the public interest to dispel any
pockets of such excessive market stability.

A powerful

force for dispelling such pockets of stability has
been created by the recent rapid spread of bank holding
company organizations into new services and new geographic
markets.




Time after time, the intrusion of an out-of-town

- 16 bank holding company affiliate into an existing
market has apparently stirred price reductions or
service improvements.

It has been impracticable to

document the extent or duration of that improved
treatment of customers.

The changes, however, have

clearly been in a beneficial direction from the point
of view of customer interests (so long as the penetration
of markets is not accomplished by predatory behavior),
and may in the long run represent the strongest set of
arguments for the bank holding company format.
Such benefits are most likely, of course, when
the bank holding company is moving out of its existing
markets and seeking to penetrate new ones.

Consequently,

bank regulatory authorities appear more inclined to
approve ventures into new geographic markets than added
acquisitions in local markets in which the applicant is
already a significant participant.
To some commentators, the vision of a moderate
number of large, strong and diversified bank holding
companies spreading out in overlapping fashion in a




- 17 multiplicity of geographical markets seems to promise
a practical optimum in the competitive provision of
banking and related services.

To me, however, that

vision is clouded by the attendant temptation to
engage in oligopolistic behavior that may sometimes
afflict firms facing each other in a number of markets.
The more closely adjacent those markets are, and the
fewer the organizations competing in each, the greater
the temptation to oligopolistic behavior is likely to
be.
Economic theorists have tried to conceptualize
these intermarket relationships of firms in several
ways.

The concept of linked oligopoly is clearly

applicable to these cases, and to some extent the
more diffuse ideas of concentration of resources and
conglomerate power can be made relevant.

Other

economic theories have emphasized what amounts to
the other side of this same coin, namely, the
beneficient competitive effect that can flow from
strong firms close by that have not yet entered that




- 18 particular market.

The concepts of potential

competition and, more recently, probable future
competition, fall into this category.
Another and more novel concept of competitive
discipline also seems to me to be applicable to these
situations.

That concept concerns the possibility

that, if badly enough treated, customers of a bank in
one market might be willing to travel to an adjacent
market to seek banking services.

I have articulated

this idea -- labeled the "threat of customer exit" -at greater length in the attached appendix, along
with summaries of the economic and legal status of
other concepts just mentioned.

Suffice it to say

here that such concepts of potential intermarket
relationships among banking firms and their customers
argue for caution in permitting bank holding companies
to expand into geographical markets that are closely
related.

I believe that economic research is making

it gradually clearer that competitive forces can flow
from sellers of banking and related services in nearby




- 19 markets.

Therefore, in cases in which local competitors

are not sufficiently strong and numerous to assure
vigorous competition by themselves, preservation of
additional banking organizations in nearby markets may
help to promote competitive vigor.
Bank holding companies whose acquisitions
are dispersed widely enough to avoid interfering with
this pro-competitive influence from banks in nearby
markets may be adopting the optimal long-run growth
strategy from the point of view of the bank customer.
Hopefully, enough research into this and related
iss.ues will have been stimulated to develop progres­
sively clearer guidance in such judgments for banks,
bank customers, and regulators alike.




- 20 IV.
It is clear that the bank holding company
form of organization has become an important feature
of the United States financial system in just a few
years.

In this paper, I have argued that the

magnitude of the bank holding company movement,
combined with its aggressive management, has signif­
icant implications for financial stability as well
as for the stability (or degree of competition) of
intermarket relationships among firms.
I have suggested that there are several actual
or possible tendencies within the bank holding company
movement that would generally be regarded as favorable
to stability and several which are unfavorable.

Thus,

with respect to stability of financial institutions,
favorable effects are associated with (1) holding
company acquisition and support of some smaller,
financially weak banks and nonbank firms that had a
relatively high risk of failure, (2) their relatively
aggressive community lending policy, and (3) their




- 21 potential for diversification of risks across numerous
markets and services.

One major source of instability

is associated with the relatively high degree of
leveraging found in bank holding company organizations.
Nonbank affiliates tend to be more highly leveraged
than similar independent firms, and holding company
banks themselves are often somewhat more leveraged
than independent banks.

This situation can be

aggravated in those cases where double leveraging
occurs at the holding company level.

A second

source of instability is the riskier quality of
assets that some nonbank affiliates may bring into
their bank holding company organizations.
With respect to the influence of bank holding
companies on the stability of market relationships,
the most pertinent questions arise from the multi­
market dimensions of their activity.

My review of

the concepts that attempt to deal with firms in a
multi-market setting indicates that some of these
concepts view diversification as having a favorable




- 22 (destabilizing) effect on interfirm relationships
while others find an unfavorable (stabilizing) effect.
I have added to this list of ideas by suggesting that,
at least in some situations, exiting customers may be
an influential agent in intermarket relationships
between firms.
Research that would further illuminate the
stability issues that I have raised in this paper
could provide an important ingredient for the
formulation of rational public policy toward the
evolving role of bank holding companies in the
American financial system.

I sincerely hope that

those of you in the academic community will find
sufficient challenge and stimulation in these issues
to apply your talents to them.




- 23 Appendix: Conceptualizing the Intermarket
____________ Relationships of Firms__________

Since Chamberlin's classic work on monopolistic
competition, economists have devoted increased attention
to the effects of varying market structures on the
certainty or stability of the relationships between
firms operating in the same market.

Theory, combined

with numerous empirical studies, indicates that as the
number of firms in a market increases and concentration
decreases, competitive performance improves.

Within the

Chamberlinian framework, this outcome is attributable
to the increased uncertainty among firms as to their
rivals' actions and reactions because of the larger
number of market participants.

In other words, it is

easier for two or three firms to reach and maintain a
mutually favorable agreement (overt or tacit) than it
is for 100 firms.

While this theoretical framework has

been very useful for analysis of the interrelationships
of firms operating in the same market, it is not directly
applicable to the intermarket relationships of firms.




- 24 Consequently, the present state of the art provides
us with inadequate insight into the competitive
implications of bank holding company expansion into
new product and geographic markets.
I will briefly review the economic and legal
status of several concepts that have been developed
to analyze the multi-market relationships of firms,
including one with which I have recently been
experimenting.

The concepts include (1) potential

competition, (2) probable future competition, (3) linked
oligopoly, (4) conglomerate power and (5) the exploratory
notion of what I call customer exit.

To emphasize the

lack of a systematic framework for analyzing multi-market
firms, I might note thau the first two concepts suggest,
directly or indirectly, that diversification into new
markets will provide a destabilizing, i.e., pro-competitive
force.

In contrast, the third and fourth concepts contend

that substantial diversification by large firms results
in increased stability of firm relationships within
individual markets or groups of markets.




- 25 Theory of potential competition
The theory of potential competition holds that
a firm outside a market (potential entrant) can have a
pro-competitive influence on the pricing behavior of
established firms in that market due to the threat of
its entry.

Actual entry need never occur for this

influence to be manifested.

This theory of the inter­

market relationships of firms is the best known and
most widely discussed in both economics and law.
Indeed, it has been successfully applied by the
antitrust authorities in contesting industrial mergers
in the courts (e.g., the Proctor and Gamble Case, 1967;
Penn-Olin Case, 1964; and El Paso Case, 1964), although
it has not yet been successfully applied to bank mergers.
The theory of potential competition is based on
two related concepts:
pricing.

barriers to entry and limit

Barriers to entry are those characteristics

(e.g., product differentiation and scale economies) of
an industry that increases the costs of entry to all
potential entrants, thereby permitting the established




- 26 firms to charge higher than competitive-level prices
without attracting new entrants.

The limit price is

the highest common price that sellers think they can
charge without attracting a new entrant.

A successful

limit price policy by established firms requires that
they price below that price at which the potential
entrant can incur the costs of entry and still operate
profitably.
Unfortunately, while there is a great deal of
empirical analysis that has been done with respect to
barriers to entry, there is virtually none on the
concept of a limit price.
Probable future competition
The concept of probable future competition
contends that a potential entrant may have a procompetitive impact on a market because at some time
in the future it may enter and deconcentrate the market.
This concept was not developed in the economic
literature but rather has evolved almost haphazardly
in merger analysis, often being interjected in connection




- 27 "
with discussions of the theory of potential competition.
Nevertheless, there is a sound economic rationale for
the application of this concept, since economic theory
supported by a substantial body of empirical evidence
suggests that increasing the number of firms so as to
deconcentrate a market tends to induce more competitive
performance.
As with its analytical development, the legal devel­
opment of probable future competition has typically been
haphazard, being comingled -- sometimes apparently inadver­
tently -- with discussions of the theory of potential com­
petition.

Recently, however, both regulatory authorities

(including the Federal Reserve Reserve) and the courts have
distinguished the concept of probable future competition from
potential competition.

Thus, for example, the concept of

probable future competition has been brought out as a distinct
issue in several recent Supreme Court cases, including
Falstaff, Connecticut National Bank, and Marine Bancorporation.

In the Falstaff case, the theory of potential

competition (with established legal precedents) was




- 28 applied by the Court so that it explicitly reserved a ruling
on the separable issue of probable future competition.
In the two subsequent bank cases, the Court considered
probable future competition but gave it only limited
treatment because of the limited evidence brought to
bear on the issue.
In view of its relatively recent origins

and

its capacity for empirical documentation, the concept
of probable future competition seems ripe for further
economic and legal development.
Linked oligopoly
The linked oligopoly hypothesis observes that
as the larger firms in various markets diversify into
other markets they will meet face-to-face in an
increasing number of markets.

As a consequence,

competitive actions in one market are not independent
of other markets, since aggressive action in any one
market may be countered by a rival with aggressive
action in some other market where the two firms meet.




- 29 These large rivals become aware of their multi-market
interdependence and common interests and may seek to
avoid a competitive struggle in the same ways as
traditional single-market oligopolists.

In essence

then, the hypothesis is an extension of basic oligopoly
theory to a multi-market setting.
The linked oligopoly hypothesis has received
comparatively little attention from antitrust authorities
and economists.

However, the Justice Department's recent

concern with Statewide banking structure led it to apply
the linked oligopoly hypothesis (along with potential
competition and probable future competition) in the
recent Marine Bancorporation and Connecticut cases before
the Supreme Court.

The Court rejected that argument on

grounds of lack of evidence and legal precedent.

It did

not, however, issue a general condemnation of the linked
oligopoly hypothesis.

To my knowledge these are the

first court tests of this hypothesis.

It would appear,

therefore, that in both economics and law the linked
oligopoly hypothesis is in an early stage of develop­
ment and there should be considerable opportunity for
refining and applying it in the future.




- 30 Conglomerate power
The conglomerate power hypothesis was first
articulated in the mid-1950's and has been a subject
of debate ever since.

This hypothesis holds that

large conglomerate (diversified) firms have unique
economic power accrue

to them that is independent

of monopoly power associated with individual markets.
This conglomerate power may be manifested in certain
forms of anticompetitive behavior, including cross­
subsidization, reciprocity and tie-in arrangements.
Because of the typically large size of diversified
firms, this behavior, or its threat, is likely to
inhibit aggressive behavior by smaller firms.

While

there is no evidence of a general nature regarding
this type of conduct because of obvious data problems,
there is some analytical and legal case evidence
illustrating the occurrence of these practices.
The legal development of the specific issues
raised by the conglomerate power hypothesis is rather
complete, in that each of the forms of anticompetitive




- 31 conduct outlined above are expressly prohibited by
the antitrust laws and each has been accepted in the
courts.

The economic development of the concept is

far from complete, largely because of inadequate
theoretical development and a lack of product-line
data on individual firms that would permit hypothesis
testing of a general nature.
Threat of customer exit
To the foregoing list of more familiar concepts
dealing with the intermarket relationships of firms, I
believe one novel idea might usefully be added -- namely,
the threat of customer exit.

While the emphasis of the

four concepts outlined above is on the direct relationship
between sellers, the concept introduced here suggests that,
at least in the banking industry, customers may exert a
constructively destabilizing force by their express or
implied threat to move from one market to another in search
6/
of more satisfactory services.
Recent experience with

6 / Even though some customers travel to another "market11,
it does not necessarily imply that there is only one instead
of two markets. The distinction between markets will depend
on the extent to which long-run price differences can persist
between them.




- 32 bank holding company acquisition cases suggests to me
that this phenomenon may be most important between
relatively small markets in which banking alternatives
are limited.

The following amplification of this c on­

cept may permit its applicability to be judged more
accurately.
The traditional conception of the theory of
potential competition contends that the price constraint
created by a firm outside a market arises from the threat
that the outside firm will enter the market.

Even in

those situations where the price-constraining influence
of the threat of entry may be small, there is another
avenue through which the outside firm exercises a
restraining influence on the price behavior of established
firms.

This arises from the threat of customer exit .

This threat continues to operate as a moderating force
even when barriers to entry are high and the influence
of potential entry is weak, because of the substantial
cost differences between firm entry and customer exit.




- 33 The outside firm is faced with the high cost of
overcoming entry barriers, information costs, uncertainty
due to information and alternative reactions to entry,
an irrevocable decision in the short-run, and a consid­
erable time lag between decision to enter and implementa­
tion.

In contrast, regardless of barriers to entry,

customer exit can be accomplished rapidly, usually with
little uncertainty as to the effect of exit, and the
decision probably can be promptly reversed.

The estab­

lished firm in a market, in recognition of the potential
exit of at least some of its customers, is likely to
develop a second limit price to inhibit such customer exit.
And, because the cost of customer exit is usually so
much lower than that for firm entry, the limit price
arising from the threat of exit should tend to be lower
than the limit price associated with firm entry.

The

threat of exit may not be as powerful as the threat of
entry, because actual entry could lead to a permanent
loss of a whole range of customers whereas actual exit
is most likely to involve only one class of "frontier"
customers who could conceivably be lured back.




However,

- 34 if such a second and lower limit price develops, there
will be a spillover effect to the advantage of all
customers as a result of the leverage of the one class
of potentially exiting customers.
The implications of this concept for bank merger
policy is that banking organizations that may offer a
reasonable alternative source of banking services to
customers exiting from another market with few banks
can be an important contributor to competitive behavior
in that latter market.

Accordingly, authorities should

be wary of permitting such banking organizations to enter
that other market by acquisition.
This concept of the threat of customer exit is
very hypothetical, barely explored empirically and as
yet untested in the courts.

It seems to lend itself,

however, to either large-scale or small-scale empirical
investigation.

That, and its potential implications

for public policy, seem to me to make it a promising
area for further economic research.




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