Differentiated attributes and service-quality competition as sources of portfolio interdependence and diverging scales in banking

Abstract

Why are banks’ asset–liability decisions interdependent, and why do we observe both large and small banks? We introduce convex costs in a model with both horizontal and vertical quality differentiation, finding that, as long as a single bank spends on quality attributes, strategic quality rivalry causes the portfolio decisions of all banks to be interconnected, generating portfolio interdependence regarding choices among assets and liabilities at each bank, including banks that forego vertical quality provision. In addition, diseconomies of scale allow banks to remain profitable at different scales of operations. • We model banks that can expend on quality attributes to gain market share. • Strategic rivalry causes the portfolio decisions of banks to be interconnected. • Our model explains how both large and small banks can co-exist in the same market. • Because of convex costs, less efficient banks become niche players.