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ABSTRACT Empirical research about structure, conduct and performance in banking markets has developed mostly independently from the microeconomic theory of banking. The present paper reviews the literature by focusing on the links between theoretical and empirical research. It considers basic conditions, variables of market structure, conduct and performance and public policy special to the banking industry. It is shown that the competitive conditions are different in different market segments, and that the trend towards universal banks which are active in different geographic markets gives new challenges to research.
Key words: Banking; Industrial organization; Structure-conduct-performance paradigm; Market imperfections; Public policy.
1. Introduction
In his seminal paper "What's different about banks?" Eugene Fama (1985) explains the comparative advantage of banks vis-d-vis capital markets by the superior capability of banks to provide debt with inside information. Within the theory of asymmetric information, Diamond (1984) shows that a special role of banks is to minimize the agency costs between borrowers and lenders by monitoring the borrowers at low cost. As shown by Diamond and Dybvig (1983), another special function of banks is to transform illiquid assets into liquid liabilities, providing insurance against liquidity risk with private information to agents.1 Hence, banks arise because of incomplete and asymmetric information in the financial markets.
Whereas since the 1980s the microeconomic theory of financial intermediation has developed within the theory of incomplete markets and the `new institutional economics' (for surveys see Swank, 1996; Thakor, 1995; Bhattacharya and Thakor, 1993; Neuberger, 1994), many empirical studies on market structure, conduct and performance in the banking sector have been conducted from the beginning of the 1960s (for surveys see Berger, 1995; Gilbert, 1984). However, the hypotheses tested there are mostly derived from the theory of oligopolistic goods markets, and it is rarely asked whether they can be applied to the banking markets without restrictions. Attempts to base the empirical research on IO topics in banking on the micro-economic theory of the bank are new (e.g. Hannan, 1991b; Calem and Carlino, 1991). They follow the new approach of research in industrial organization where empirical studies on single industries are closely linked to theory (Bresnahan and Schmalensee, 1987; Martin, 1993: 9; Schwalbach, 1994). In the last decade, IO-related research in banking has tremendously increased, being driven...