The Horizontal Integration of the Banking Firm, Credit Rationing and Monetary Policy

Abstract

The purpose of this paper is to derive the implications of horizontal integration of functions within a banking firm for the equilibrium interest rate, the degree and structure of credit rationing and the operation of monetary policy. A banking firm usually handles, besides credit, a number of other activities like demand and time deposits, foreign exchange transactions and in some countries like Israel even brokerage functions. It is widely recognized, certainly within the banking business community, that there is a positive association between the propensity of a customer to generate various businesses in the bank and the amount of credit that he obtains from the bank. Other things being equal, one would expect that such a relationship would imply that customers with more business would obtain more credit or better terms, or both. Empirical evidence on this point supports this implication. For example Harris [3, p. 238] finds that the value of the customer relationship is an important consideration in the allocation of credit to customers. In a related work, Harris [2] finds that the value of a customer as a depositor or a source of collateral business is an important consideration in lending decisions, particularly during tight money periods. In one way or another, credit as a means to influence the demand for banking services facing the bank is implicit in the theoretical literature on banking as well. Hodgman [4] and [5] considers the allocation of credit to customers as a means to increase the size and durability of the customer's deposit with the bank. The long-run value of a customer as a source of deposits and other business as a factor which influences the credit allocation decision of the bank appears also in Kane and Malkiel [8]. The purpose of this paper is to explore the implications of the existence of a positive dependency between the demand for banking services' and the amount of credit granted to a customer, for the nature of equilibrium in the credit market and the effects of monetary policy. This is done for an individual representative bank which operates under oligopolistic conditions since this seems to be the usual market structure of the banking industry in many countries.2 The basic model of a bank which sells credit and a composite banking service, the demand for which is positively related to the amount of credit the bank allocates, is presented in Section 1. It is shown that if the bank is constrained to charge all customers within a certain class the same rate of interest there will be some rationed customers even when the bank sets the rate of interest at its equilibrium level and even if there is no risk of default. Customers who have a higher marginal propensity to buy banking services when granted credit will not be rationed. Those with such low marginal propensities will be rationed. The equilibrium rate of interest will be lower than in a situation with no demand dependencies, the non-rationed customers will get more credit and the rationed customers