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Out-of-State Entry and the Cost Efficiency of Local Commercial Banks

Abstract

The Riegle-Neal Act allows commercial banks to operate with complete freedom across state lines beginning in June 1997. In an attempt to gauge the impact that full interstate banking will have on the industry, we examine bank performance data from states that passed interstate banking laws prior to the Riegle-Neal Act. We estimate cost inefficiency for banks that operated exclusively in local markets in 1992, then regress those estimates on the intensity of out-of-state activity in those markets during that year.

In the years immediately following the removal of barriers to out-of-state banks, we find that increased entry is associated with increased inefficiency for local banks. However, this appears to be a short-run phenomenon only -- in markets that have allowed out-of-state entry for at least six years, we find that inefficiency declines in response to increased entry. On average, cost inefficiency at local banks declines by about 3 percent for each additional year that banks face interstate competition.

What do our results portend for the performance of local banks under the Riegle-Neal Act? Interstate competition is already well under way in many metropolitan markets because of state-by-state reciprocal compacts. For local banks in these markets, Riegle-Neal will likely enhance the forces of competition by expanding the number of potential entrants. In markets for which Riegle-Neal marks the first introduction of interstate competition, our results suggest that interstate competition will gradually deliver substantial gains in cost efficiency over the course of the next decade.

Disclaimer

As with all OCC Working Papers, the opinions expressed in this paper are those of the author alone, and do not necessarily reflect the views of the Office of the Comptroller of the Currency or the Department of the Treasury.

Any whole or partial reproduction of material in this paper should include the following citation: DeYoung, Hasan, and Kirchhoff, "Out-of-State Entry and the Cost Efficiency of Local Commercial Banks," Office of the Comptroller of the Currency, E&PA Working Paper 97-7, April 1997.

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