An analysis of endogenous sunk cost competition in the banking industry

Abstract

Banks play a critical role in providing liquidity to an economy by transforming small deposits into large loans. Due to the importance of the banking system, bank performance has been an area of keen interest for regulators. Traditionally, regulators saw competition in the banking sector as a source of excessive risk-taking, adversely impacting bank performance and threatening the system's stability. Consequently, regulators globally supported a concentrated banking market. However, there was a paradigm shift towards the last quarter of the 20th century. Assuming deregulation will compete away inefficiencies stemming from concentrated market structure, regulators started desiring greater competition in the banking industry. As a result, globally, regulators undertook several measures to reduce the market power of national champions. But, contrary to conventional economic theories and regulatory expectations, concentration in most banking markets remains elevated. This situation concerns the authorities; however, the literature offers no clarity on what enables banks to forestall competition in expanding markets. The present study addresses the issue by integrating Sutton's (1991) philosophy of endogenous sunk cost (ESC) with established theories in the banking literature. According to Sutton (1991), as the size of the market increases, incumbent firms attempt to soften competition through "a proportionate increase in fixed cost" in quality (p. 47). The author argues that fixed investments in the vertical form of product differentiation by a few large firms in an industry pushes rivals to either match the quality of their larger peers or quit the market. Consequently, as the market size expands, a few large firms incur higher ESC, discouraging new participation on the one hand and triggering consolidation on the other, resulting in a concentrated market structure. Notably, as investments in quality are a firm-specific approach to handling competition beyond the purview of regulators, banks strategically invest in ESC to configure the market structure, quashing regulatory efforts to fragment the market. In conclusion, this research addresses significant voids in the banking literature. The study reveals the importance of ESC investments in evaluating banking market competition. Additionally, the study establishes the non-monotonic relationship between IT sunk cost investments and bank profitability.The study's findings give banking researchers and regulators valuable direction in assessing the competition in the banking markets. Additionally, it encourages supporters of the IT productivity paradox in banking to reassess their position following the discoveries of the present study.

Date of Award	2022
Original language	English