Banks as ‘fat cats’: branching and price decisions in a two-stage model of competition

In this paper we develop an empirical two-stage model of price competition for the banking industry that incorporates the choice of capacity in the form of new branches. This is achieved by supplementing the customary two-equation framework (demand plus first-order condition in the loan market) with the addition of a third equation that endogenizes the investment decision regarding the branch network. The model is estimated using data on a group of large and medium Italian banks for the years 1995-2009. The results show that the conduct of banks is significantly more competitive than a Bertrand-Nash equilibrium, and support the rejection of the simple one-stage specification, which underestimates the degree of competition. In the taxonomy of Fudenberg and Tirole (1984), the banks in the sample are found to behave as ‘fat cats’, overinvesting in the branch network so as to keep prices high and accommodate entry.