Becker Friedman Institute
for Research in Economics
The University of Chicago

Research. Insights. Impact. Advancing the Legacy of Chicago Economics.

Beyond Asset Prices: A Deeper Look at the Financial Industry

Industrial organization initiative examines financial products from firm, consumer viewpoints

Traditionally, scholars have approached the analysis of financial institutions and products from the perspective of academic finance, focusing on asset pricing, valuation, capitalization ratios, and the like. Yet this lens offers a narrow view of a sector that bears distinct similarities to other markets in which consumers choose companies and products based on broad range of variables.

Applying the model-driven empirical approaches that industrial organization experts use to understand firm and consumer behavior can yield important insights about the financial sector. On May 6, scholars whose work spans both academic finance and consumer and firm behavior convened at The Becker Friedman Institute for a conference highlighting this approach.

The conference considered different aspects of the financial markets, including banking, personal finance, mergers and acquisitions, and treasury actions. It examined such issues as how consumers view financial products, how financial firms compete, and how regulations impact the behaviors of consumers and firms. Together, the papers demonstrated the power of stretching the boundaries of both empirical models and subject matter to produce new insights.

Understanding Institutional and Consumer Behaviors

Research papers approached the banking industry from both the demand and supply sides of the market. Economists considered such issues as how consumers respond to information about bank solvency, what variables guide the way bank networks compete locally, and how capital requirements shape banking industry dynamics.

In “A Tale of Two Runs: Depositor Responses to Bank Solvency Risk,” researchers used depositor-level data from a small commercial bank in India that experienced two different shocks that led to bank runs—one motivated by the failure of a large local bank and the other resulting from disclosure of the small bank’s precarious financial position. This data revealed how different segments of bank depositors—and bank employees—responded to various public and non-public signals, and whether their actions reflected the true solvency of the bank. Understanding these stakeholder groups and their behaviors helps banks understand the relative fragility of their depositor bases and can help inform both bank strategies and regulatory initiatives.

Empirical models can also help economists understand how banks compete in local and national markets in terms of product offerings, pricing, and geographical distribution of branch offices. Banks base these decisions on more than simply financials; they also differentiate themselves locally based on price, quality, and other strategic variables. One paper presented a structural approach that focuses on the geographic dispersion of savers and borrowers. Preliminary results suggest that consumers favor branch networks for both deposits and loans, that there is a home-bias in lending, and that internal bank liquidity facilitates or reduces the costs of lending.

The regulatory environment plays an equally important role in bank success, and macroeconomic models can help inform regulatory policies governing capital requirements, examine the impact of injections of liquidity on lending volumes, and help understand how policy changes that affect big banks spill over to the rest of the industry. One paper studying these issues suggests that a rise in capital requirements leads to a significant reduction in bank exit probabilities, but also to a more concentrated industry with fewer small banks.

New Approaches to Financial Products

Passage of Dodd-Frank legislation has shifted the industry’s focus from bank oversight to product market regulation. As a result, economists are now studying how banks and consumers interact with specific financial products and services.

One study used the FINRA database of all financial advisors to examine how widespread misconduct is across firms, where and at whose expense this maleficence is occurring, and how effectively the industry polices itself. The study found that one in 13 advisors faced at least one report of misconduct, and many were repeat offenders. What’s more, 44 percent of those dismissed found employment with another firm—usually ones with higher tolerance for misconduct. Victims of misconduct typically reside in counties with lower education levels, in wealthier areas, and in areas with high retiree and elderly populations.

Households currently hold approximately $8 trillion in equity mutual funds. With the precipitous recent growth of this investment category, economists seek insight into how specific fund styles perform—and how consumers factor past performance into their current investment decisions. In June 2002, Morningstar changed its star rating system to control for “style” exposure—a move that instantly changed the star rating of 60 percent of the funds. Funds that benefited from an increase of one star increased their fund size by 20 percent over the next two years, grew ownership by 10 percent at the stock level, and generated a 12 percent increase in returns.

The US Treasury Auction system is another huge market, generating $500 billion in transactions each day; in 2013 it accounted for $7.9 trillion in debt investment. One paper collected robust data from this important market and developed a new model to study how bidders of the market’s three different classes behave, whether some bidders possess significant market power that allows them to extract monopoly rents, and whether changes in the mechanism could lead to significant revenue/efficiency gains.

Most investment banks advise clients on mergers and acquisitions, and this advice often includes market analysis that identifies current opportunities. The study “Innovation Activities and the Incentives for Vertical Acquisitions and Integration” applied industrial organizational thinking to this financial product to consider the circumstances and timing of vertical acquisitions. Using a large panel dataset and textual analysis of form 10K documents, the study finds that innovation activities play an important role in transactions. Companies are more likely to acquire suppliers with realized rather than unrealized innovations because patents become a legal property right they can control. Owners of companies with unrealized innovation are less likely to sell because they do not want to sacrifice the undetermined upside.

Rob Squire