Vertical Integration to Avoid Contracting with Potential Competitors: Evidence from Bankers Banks

1
Vertical Integration to Avoid Contracting with
Potential Competitors Evidence from Bankers
Banks

• James A. Brickley, James S. Linck and Clifford W.
  Smith, Jr.

2
Fundamental Business Decision

• Should the firm make or buy its inputs?
• With respect to banking
• Loan participation, check clearing,
  asset/liability management, credit card services,
  advisory

3
Make or Buy?

• Most past research focused on
• Transaction costs, property rights, market power,
  government regulation
• Empirical support for
• Integrate to avoid hold-up problems associated
  with firm-specific investment
• Market power and government regulation
• However
• Significant variation exists in settings where
  these are relatively unimportant

4
Our Focus

• Make vs. buy decision in the banking industry in
  the latter part of the 20th century
• Geographic deregulation and technological change
• Community banks exposed to greater competition
  from larger banks on which they previously relied
  for correspondent services
• Industry formed business cooperatives called
  bankers banks for correspondent services
• What explains it?
• Specific investment relatively unimportant
• No noticeable change in market power in these
  markets
• Banking becoming less (not more) regulated

5
Business Cooperative

• Firms jointly own a primary supplier or
  distributor

Supplier
Firm A
Firm B
Firm C
Distributor
6
Examples of Business Cooperatives

• Agriculture
• Hardware stores
• Grocery stores
• Drug Retailing
• Moving Industry
• Mutual Insurance
• Joint Ventures
• Banking

7
Ace Hardware

• Retailer-Owned Cooperative wholly owned by
  independently operated store owners
• 2007
• 4,600 Ace Stores in all 50 states and 70
  countries on six continents
• 12 billion in sales

8
Business Cooperatives and Organizational
Alternatives

• Purpose Economies of scale in the production /
  acquisition of inputs or the distribution of
  their products
• Organizational alternatives
• Market transactions
• Long-term contracting
• Vertical integration

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Contracting CostsBusiness Cooperatives

• Benefits
• Maintains local asset ownership
• Avoids hazards of contracting between to
  independently owned firms
• Costs
• Free-riding in monitoring and decision making of
  jointly owned company
• Collective action problems owner conflicts
• Antitrust

10
General Economic Prediction

• Expect to see cooperatives in environments where
• Costs of independent contracting are high
• Benefits of local asset ownership are large
• Costs of cooperative organization are low
  (free-riding, collective action issues and
  antitrust)

11
Objectives of this Paper

• General Objective
• Provide new evidence on the determinants of
  vertical organization and the economic reasons
  for business cooperatives
• Specific Objective
• Provide evidence on the choice that small banks
  make between long-term contracting with a large
  bank (correspondent banking) joining a business
  cooperative (bankers bank)
• Test predictions on when and why bankers banks
  first formed and who uses their services

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Why are Bankers' Banks Particularly Interesting

• Unique opportunity to provide evidence on
  vertical choice.
• In contrast to industries with long-standing,
  static organizational patterns, we can observe
  both important environmental changes and
  variation in organizational responses.
• This allows us to identify more clearly the
  economic factors that are likely to affect
  vertical organization and to provide evidence on
  their explanatory power.
• The downside is that our evidence is from one
  regulated industry.

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Changes in the Banking Industry 1935-2005 (Table
1)
14
Banking Industry Deregulation(Table 2)
15
US. Banking Industry NowSmall Banks Still Around
(Table 3)
16
California Banking Industry NowSmall Banks Still
Around (Table 3)
Past Research Small (community) banks are
most prevalent in small urban and rural areas
where it is important to give office managers
broad decision authority and ownership incentives
(e.g., Brickley, Linck, Smith (2003))
17
Changes in the Banking IndustryEffects on
Vertical Organization

• Prior to 1975 all community banks had
  correspondent relations with large money center
  and/or regional banks
• Massive regulatory and technological change
• Increased likelihood that community banks will
  compete with large banks over retail and
  commercial customers
• Increased likelihood that a partner in a
  correspondent relationship will disappear due to
  a takeover or merger

18
Changes in the Banking IndustryEffects on
Vertical Organization

• These developments reduced the apparent
  willingness of community banks to
• Share information with large banks (e.g., about
  customers in loan participations)
• Make specific investments in correspondent
  relationships

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Changes in the Banking IndustryThe Bankers Bank

• Chartered under national and state banking laws
• First bankers bank was formed in 1975
  (Minnesota)
• Today there are 21 bankers banks providing
  services to 1000s of community banks throughout
  the United States

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Hypotheses

• Bankers Banks were an organizational response to
  the increased contacting costs of correspondent
  banking between a community bank and large bank
• Achieve economies of scale
• Maintain local asset ownership
• Alternative Contract with an independent provider

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Hypothesis 1 and 2When and Why They First Arose

• Bankers banks are most likely to be formed
• In markets with a lot of community banks
• Sufficient customer base
• In markets with most prior regulation
• The change in potential competition drove the
  need for the bankers bank
• Thus, states that were mostly strongly regulated

22
Hypothesis 3 and 4Who Uses a Bankers Bank

• Community banks that are most likely to face
  competition from large banks are the most likely
  to join a bankers bank
• Community banks located in areas where the
  competition from large banks is likely to change
• Near large metropolitan areas or in midsize urban
  areas
• Community banks with a large fraction of loans
  based on hard information or with large
  customers
• Larger fraction of construction loans and
  mortgage loans customers with large deposits

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Bankers Banks

• National and state charters
• Provide services only to other banks
• Owned by their customer institutions, who also
  sit on the board
• Can provide services to banks that are not
  shareholders
• Shareholders receive preferred pricing, voting
  rights and dividends
• Generally operate in more than one state
• Unlikely to merge with another bank (individual
  banks cannot own more than 5 of the shares)

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Bankers Banks (Table 4)
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Typical Services

• participation loans
• cash letter services (check clearing)
• sweep accounts
• on-line correspondent banking
• credit card services
• international services
• consulting services, audit and compliance
  services, investments
• federal funds transactions
• mortgage lending programs
• direct loans to officers and directors of
  community banks

26
Hazards of Corresponding with a Large Potential
Competitor

• Steal your customers
• Can have incentives to increase your costs (Salop
  Scheffman (1987))

27
Bankers BanksTypical Marketing Statement

• As corporate megabanks expand, correspondent
  service to non-affiliated banks declines.
• Being commercial banks, such banks compete with
  other financial institutions, including their own
  correspondents, for business.
• In fact, you may find that they use information
  you provide them through the correspondent system
  to compete for your customers, furthering their
  interests at your expense! Since a bankers' bank
  cannot deal with the general public, such a
  conflict of interest cannot occur. Your interests
  are our interests.

Bankers Bank of Kansas, N.A. http//www.bbok.com/
28
Statement by a Community Banker

• Many client banks today are faced with a
  paradox. To attract business, they must offer
  services that often are available through their
  large competitors operating as correspondent
  banks, but that places them in the unenviable
  position of doing business with the competition.
• Why did we invest in Bankers Bank? It is
  simple, we didnt want to feed fees to the
  gorilla that could turn around and eat us up.
• Thomas R. Burton, President and CEO
• Hamden Bank
• Springfield, MA

29
From the Bankers Bank Council

• A bankers bank is a correspondent bank that is
  owned, operated, and directed by the independent
  community banks it serves. Correspondent banking
  isn't a sideline for a bankers' bank - - it's our
  only business. And because many customers are
  also shareholders, we're answerable to them not
  only as our customers, but also as investors.
  Superior service and competitive pricing are the
  result. Bankers' banks are the answer.
  Bankers' banks can do everything a major holding
  company correspondent bank can do, but bankers
  banks do not compete for your customers.

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Empirical Results

• First bankers bank in 1975, most (14 or 67)
  formed in the 1980s (Table 3)
• Coincided with relaxation of restrictions on
  geographic expansion (Table 2)

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Regulatory Chg/Concentration (T5)
32
Independent Variables (Table 6)
33
Correlation of Ind Variables (Table 6)
34
Is a BB HQd in State? (Table 7)
35
Is Bank a BB Customer? (Table 8)
36
Is Bank a BB Customer? (Table 8)
37
BB Boards (Table 9)
38
BB Boards (Table 9)
39
Bank Represented on BB Board? (T10)
40
Bank Represented on BB Board? (T10)
41
Conclusions

• Banking industry created an organizational
  innovation The Bankers Bank
• Serve the needs of community banks
• Maintain incentives of local asset ownership
  while still achieving economies of scale without
  threat of stealing their customers
• Cooperative in this setting
• Costs of independent contracting high
• Benefits of local ownership high
• Costs of cooperative low costs of free-riding
  low due to relatively frequent purchases