Relevant Market Definition in Merger Policy - A Case of Financial Services

Title: Relevant Market Definition in Merger Policy - A Case of Financial Services
Subject: Finance
Type of Paper: Research Paper

Abstract
It is believed that financial globalization, deregulation and technological advance would cause a
continuous consolidation of financial industries in the next decade with the potential positive
and/or negative effects on competition in these markets. In order to provide efficient and
smoothly operating financial market that would support growth of economies and help to
increase welfare competition authorities are called for economic analysis of almost all areas of
competition. A key part of the analysis of competition is believed to be the relevant market
definition. The paper focuses on financial industry and addresses two issues. The first is the
identification of the key problems arising in the definition of the relevant market for financial
services, especially in the EU. The second is a formulation of some recommendations for
competition authorities in defining relevant market of selected financial services, in particular
when they judge the proposed concentrations.
Key words: relevant market, financial industry, mergers and acquisitions, concentration,
competition policy, banking, insurance
Introduction
Financial globalization, deregulation, technological advance, and shareholder value creation are
the major factors that have fuelled the unprecedented level of mergers and acquisitions among
financial institutions over the past few years. Thus competition authorities should rethink their
regulatory structure in response to the emergence of large financial groups in order to assure
stability of financial systems and preserve competition on financial markets.
A constitutive part of regulatory control is the economic analysis of competition for a
competition review, which involves the definition of relevant market as typically the first
step2 in making preliminary estimate of post-merger market power. In this perspective, market
definition has becomes a key part of the merger analysis in almost all areas of
competition, in particular in countries, where competitive assessment is made on the basis of
market shares.
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The paper starts by discussing the relevance of market definition from the normative point of
view. It continues by reviewing the practice in determining the relevant product and geographic
markets in financial industry with particular focus on banking, insurance, pension funding and
other financial services both in the EU and some other countries (US, Australia and Canada).
The paper ends by highlighting the industry specific competition issues arising in market
definition and by an attempt to give some recommendations for competition authorities dealing
with financial concentration cases.
Relevant market definition and competition policy
In (industrial) economic literature, there are several concepts of market used in different
contexts. The classical definition of a market finds a clear articulation in Marshall's Principles
and leads to the definition of economic or trading market, which could be defined as "...a
collection of individuals (or associated geographic area) who face the same net price for any
particular good or service; i.e. the area over which the law of one price holds, (Gerosky 1998,
679)". Strategic market follows the needs of strategic corporate decisions inside firms. Although
there are several ways of defining strategic market boundaries3, it could be argued that a
strategic market is: "...a smallest area within which it is possible to be a viable competitor" (Kay
1990, 3).
The concept of relevant market, defined for the purpose of competition policy is designed to
identify positions of market power. Market definition is closely related to the objectives pursued
under competition policy of a country and often has a decisive influence on the assessment of a
competition case.
In the US, antitrust markets have first been defined by the Department of Justice as "...product or
a group of products and geographical area in which it is sold such that a hypothetical, profit
maximizing firm, not subject to price regulation, that was the only present and future seller of
those product in that area would impose a 'small but significant and non-transitory'
increase in price above prevailing or likely future levels (US department of Justice 1984, 13).
In determining, whether a hypothetical monopolist would be in a position to exercise market
power, the competition authority evaluates the likely demand responses of consumers to a price
increase. The nature and the magnitude of the demand responses respectively determine the
scope of the product and geographic market. In contrast, where a hypothetical monopolist would
likely discriminate in prices charged to different groups of buyers, distinguished, for example, by 
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their users or locations, the competition authority may delineate different relevant markets
corresponding to each buyer group (Horizontal merger guidelines, 1997).
European Union competition authority sees the objective of market definition as "to identify
those actual competitors of the undertakings involved that are capable of constraining their
behaviour and of preventing them from behaving independently of an effective competitive
pressure" (Commission notice on the definition of the relevant market for the purpose of
Community competition law, 1997).
In this context a relevant product market "...comprises all those products and/or services which
are regarded as interchangeable or substitutable by consumer, by reason of the products'
characteristics, their prices and their intended use" (Commission notice on the definition of the
relevant market for the purpose of Community, 1997).
A relevant geographic market "...comprises the area in which the undertakings concerned are
involved in the supply and demand of products or services, in which the conditions of
competition are sufficiently homogeneous and which can be distinguished from neighbouring
areas because the conditions of competition are appreciably in those areas" (Commission notice
on the definition of the relevant market for the purpose of Community). In the case of retail
markets, we have repeatedly defined geographic markets as a number of individual concentric
circles limited by the distance the consumers are prepared to travel in order to reach the outlet of
a competing firm (+-20km).
To assess the demand substitution the European Commission usually apply so-called "SSNIP
test" or "dominance" test.4 The Commission examines whether the involved firms' customers
would switch to readily available substitutes or to suppliers located elsewhere in response to a
hypothetical small (in range 5 - 10%), permanent relative price increase in the products and areas
being considered (EC 1997, 3-4). Current test for assessment of demand substitution thus focuses
on the structural component of a concentration.
Additionally to demand substitutability, the Commission takes into account supply side
substitutability when its effects are equivalent to those of demand substitution in terms of
effectiveness and immediacy. This means the suppliers are able to switch production to the
relevant products and sell them in the short term without incurring significant additional costs or
risks in response to small and permanent changes in relative prices.
Defining the relevant market for financial services
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The criteria to define the relevant market are generally used for the analysis of certain
behaviour in the market and for the analysis of structural changes in the supply of product.
However, this methodology might in practice lead to different results depending on the nature of
the competition issue being examined. Therefore the application of economic-wide merger
guidelines and practices has to be tailored to the specifics of the financial industry, such as the
role of legislation and regulatory supervision, the technological advance in distribution networks
etc.
The number of cases in financial industry in EU is relatively small as a considerable number of
concentrations in the industry still take place on a national level5. However, the Commission has
an important role to play in shaping the financial markets of the enlarged European Community
as further globalization of the industry is expected.
The EU record on defining relative markets in financial industry is relatively less informative
as in the most cases the proposed concentrations did not raise significant competition concerns
even on the narrowest market definition.6 Therefore, Commission has left the precise market
definition open in most cases even though merging parties have proposed their own market
definition. There are at least three reasons: i) activities of the involved companies were only
minor on the level of European union, ii) activities of the involved companies overlapped, or iii)
the markets were highly fragmented and there were many active competitors. Nevertheless, the
review of Commission's decisions regarding concentrations in financial industry could give the
national competition authorities an important guidance in defining the relevant markets.
In the following section, the overview of EU practice in defining relevant markets of three main
categories of financial services is presented: financial intermediation (J.65 NACE Classification),
insurance and pension funding (J.66 NACE Classification) and activities auxiliary to financial
intermediation (J.67 NACE Classification).
Banking
The European Commission has traditionally divided banking services into four main subsectors:
retail/customer banking, corporate banking, investment banking and financial markets.7 the
division into variations of these major groups (corresponding to individual country
characteristics or competition authority needs) is usually found in decisions of the competition
authorities also in other countries, such as US, Australia and Canada. Kahwaty et al. (2003)
similarly find that competition authorities divide the banking services into consumer services, 
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banking services for small/medium enterprises (SME), and electronic payments and fund
transfers both in the EU and the above mentioned countries.
The European Commission has traditionally divided banking services into four main subsectors:
retail/customer banking, corporate banking, investment banking and financial markets.8 The
division into variations of these major groups (corresponding to individual country
characteristics or competition authority needs) is usually found in decisions of the competition
authorities also in other countries, such as US, Australia and Canada (Kahwaty et al., 2003).
Retail banking - services for individual customers
The most segmented market is the retail/customer banking. Here individual products have
distinct characteristics and are best treated separately. The parties in the EU cases suggested a
number of possible subdivisions, including universal banking market (current/transaction
accounts), the deposit market, credit to private individuals...9 Kahwaty et al. (2003) study
customer banking in EU, Australia and Canada and find that the competition authorities tended
to treat product markets according to individual products.
It is interesting that the EU Commission, in addition to following the individual product
approach, assessed the mergers also across the various retail product markets 8they combine
different product markets). They based their reasoning on the fact that several retail banking
services (both for individuals and SMEs) are closely linked at the distribution level (one branch
of o bank, one phone or internet banking facility). The most frequently cited product markets
included: current/transaction account, personal loan, residential mortgage and saving
account/investment markets.
Current/transaction accounts were in most cases treated as a relevant individual product
market.10 the main purpose of the current/transaction accounts is to facilitate money transactions
and in this function they have relatively low substitutability. These accounts are also
used in dealing with financial institutions regarding other financial services (like obtaining loans
or purchasing a mortgage) and are frequently seen as "gateway" financial products by the
banks.11 Current/transaction accounts are usually obtained locally, that determines their
definition of their geographic market.
Savings accounts are in their nature closer to investment products then to the transaction
accounts. They have very different characteristics and are consistently treated separately and
sometimes even along with other investment products12. Similar to loans, also savings and 
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investment products tend to have larger number of suppliers and stronger competition than
current/transaction accounts. Among saving products, various fund types constitute the same
product market in the EU due to high substitutability. Take for example mutual fund, which,
unlike direct investments, enable the customer to choose from a mix of various financial
investments and provide him with fund management services. Savings and investment products
are geographically distributed through remote channels and therefore require wider definition of
the relevant geographic market than local.13
Loan and residential mortgage markets are usually treated as two separate markets due to their
distinctive nature and uses14. Canadian competition authority noted that there is only limited
substitutability between traditional bank loans and mortgages. This seems to be true also for
credit cards (much higher price), which are also consistently treated as a separate relevant
market. Although the overdraft facilities are included in the same product market as loans, the
leasing and factoring services are considered as separate individual markets. These markets are
more competitive than the current/transaction accounts due to the presence of a variety of nonbanking suppliers. Geographic market for these products is rather wide since especially
consumer loan products and credit cards are distributed over much larger distances.
Loan and residential mortgage markets are usually treated as two separate markets due to their
distinctive nature and uses15. The credit cards are consistently treated as a separate relevant
market and are not included within loans (much higher price). The leasing and factoring services
are considered as separate individual markets.
Above mentioned markets are more competitive than the current/transaction accounts due to the
presence of a variety of non-banking suppliers. Geographic market for these products is rather
wide since especially consumer loan products and credit cards are distributed over much larger
distances (national or even worldwide).
Financial sector experienced very dynamic financial innovations and development of electronic
banking. The range of financial products ever closer resembles the continuity between the
transaction accounts on one extreme of the spectrum and pure investment/saving accounts on the
other. This complicates the competition analysis since the clear division between the two is
blurred. The "hybrid" products that share characteristics of transaction and investment
functionality are difficult to separate.
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Australian competition authority set an important precedent deciding that transaction accounts
and bank issued deposit/term products are in separate product markets. The parties involved
argued that broader relevant markets should be considered to include a wide range of household
investment products pointing out the chain of substitutability. The authority explicitly rejected
this argument and found little evidence of close substitutability among the various investment
products. In rather strong contrast, the EU Commission within savings products identified a
separate market for deposits comprising current accounts, savings accounts and time deposits,
characterized by a high degree of supply-side and demand-side substitutability. Thus, there
remains a degree of uncertainty as to where to draw the line to divide this spectrum of financial
products into "mostly transaction" and "mostly saving/investment" region.
Corporate banking
We will distinguish between the corporate banking (for large corporate customers) and retail
corporate banking (for small and medium enterprises - SME). The approach conforms to the EU
Commission's distinction between the two although the EU traditionally includes SME's in the
retail banking (along with private individual customer banking). However, due to the corporate
nature of the SME banking we discuss it here.
Corporate banking for large corporate customers includes investment loans, roll-overs, shortterm products (i.e. straight loans and discount credits), guarantee credits, swaps, collective
investment funds and commercial paper. Due to small number of relevant cases in corporate
banking and the relevance of SMEs for competition practice (as they are more vulnerable to the
exercise of market power than large corporate clients, who may turn to the stock markets for
their liquidity needs), the SMEs will be our focus in what follows.
The SMEs usually purchase different financial services from the same bank where they also have
their business transaction accounts (Kahwaty et al. 2003). The main reason for this is twofold: i)
there are economies of scope for the bank - more favourable conditions, ii) the banks can
monitor the economic performance of the SME and the associated risks through the business
transaction account.
Within the banking services for SMEs competition authorities on the EU level, in the EU
countries, Canada, UK, US and Spain were concerned primarily with most frequently purchased
loans and transaction accounts and did not find good substitutes for bank loans for business.16 
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Therefore in most cases the product market was defined in terms "clusters" of products that
included loans, deposit accounts and occasionally some other services.17
A number of competition authorities found that geographically the SME financial services have
very strong local orientation.18 Again this was somewhat broader for loans and relatively narrow
for the transaction accounts. On the contrary, he EU competition authority acknowledged strong
local tendencies for these products, but due to the nation-wide activities of the providers
considered the relevant geographic market to be national.
Financial markets and electronic banking
Financial markets and investment banking include money markets operations, bond, other debt,
equity and foreign exchange trading, equity underwriting, debt underwriting, and derivatives.
There have not been many cases of mergers in this area that would raise competition issues.
There are at least three reasons for this: i) extremely quickly changing landscape of financial
products, ii) globalization of financial services and iii) from the previous resulting stiff global
competition.