Spatial competition in the banking system: Localization, cross subsidies and the regulation of deposit rates

The paper analyses a spatial competition model of the banking sector. Banks offer two kind of services (deposits and credit) and can either borrow or lend on the money market. We investigate the consequences of the regulation of rates paid on deposits. The main conclusions are as follows. Regulation first increases network size beyond social optimum. In the long run it results in lower equilibrium credit rates because of increased competition. Secondly, regulation generates tied sales contracts, by which banks propose bundles of credit and deposit services. Tied sales, in turn, motivate the introduction of cross-subsidies between the two activities, the rent levied upon regulated deposits financing lower rates in the credit market. Finally it is shown that in a regulated environment, the effectiveness of monetary policy is reduced in the sense that fluctuations of money market rates are less than fully transmitted in credit rates.