The Economics of Regional Demarcation in Banking

Abstract

The European Commission criticized cooperation among savings and cooperative banks for potentially anticompetitive effects. Using an industrial economics model of banks taking deposits and giving loans, we look at regional demarcation as one of such cooperative practices. We study two adjacent markets comprising one savings or cooperative bank that focuses on one market and one private commercial bank serving both. We acknowledge that savings and cooperative banks have atypical objective functions. We find that abolishing regional demarcation does increase total loan volume. Due to their partially nonprofit objectives, savings or cooperative banks improve market performance, and they do better without the regional demarcation that shields the private commercial bank from aggressive competition.

Full text

BANKING
120
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Simone Raab/Peter Welzel*
The economics of Regional DemaRcaTion in
Banking**
aBs TRa c T
The European Commission criticized cooperation among savings and cooperative banks
for potentially anticompetitive effects. Using an industrial economics model of banks
taking deposits and giving loans, we look at regional demarcation as one of such coop-
erative practices. We study two adjacent markets comprising one savings or coopera-
tive bank that focuses on one market and one private commercial bank serving both.
We acknowledge that savings and cooperative banks have atypical objective functions.
We find that abolishing regional demarcation does increase total loan volume. Due to
their partially nonprofit objectives, savings or cooperative banks improve market per-
formance, and they do better without the regional demarcation that shields the private
commercial bank from aggressive competition.
JEL-Classification: G21, L13, L33, L41, L44.
Keywords: Banking; Competition; Cooperation; Non-Profit Firms.
1 inTR oDu c Tio n
Since a 2007 communication on retail banking issued by the European Commission,
regional demarcation in the banking industry has recently gained considerable interest. In
its final report, the Commission stated its qualms about a lack of effective competition in
EU retail banking markets, noting especially the traditionally close cooperation within the
sectors of savings banks and cooperative banks, which play an important role in member
states like Germany, France, and Austria (European Commission (2007)). e Commis-
sion acknowledged that cooperation can result in economic and consumer benefits as
long as the banks involved are small and do not jointly possess a significant market share.
*
Simone Raab, Faculty of Business Administration and Economics, University of Augsburg, e-mail: simone.
raab@wiwi.uni-augsburg.de. Peter Welzel, Faculty of Business Administration and Economics, University of
Augsburg, e-mail: peter.welzel@wiwi.uni-augsburg.de.
**
Both authors thank two anonymous referees for their very helpful comments. We are also grateful to participants
and discussants at the 5th European Banking Symposium in Maastricht, the 10th GEABA Symposium in Vall-
endar, and the 8th Workshop on Economic and Business Policy in Sion. We especially thank Thomas Gehrig for
his very thoughtful comments.

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However, the Commission also indicated that a more serious analysis of the competitive
effects of cooperation would be appropriate when the combined market position of the
cooperating banks threatens to limit competition. By October 2006 the Commission
had used a questionnaire to ask the umbrella organization of the savings banks and the
cooperative banks to explain the legal, organizational, and economic foundations of their
respective sectors (Scheerer (2007)).
In its accompanying staff working paper, the Commission’s Directorate-General for
Competition pointed out that the presence of savings and cooperative banks leads to
relatively low concentration ratios in the German banking industry on the one hand,
but on the other hand, it may damage competition through regional market sharing
and other cooperative arrangements among these banks (European Commission, Direc-
torate-General for Competition (2007, 19/39)). In the three-pillar structure of Germany’s
banking industry, savings banks and cooperative banks refrain in principle from competing
with each other in their lending business and focus on competition with banks from the
other two pillars1. Representatives of the groups of savings banks and cooperative banks
claim that this rule contributes to more effective competition, but the Commission was
concerned that regional demarcation might in fact lower competition intensity. Regional
demarcation was explicitly included in the questionnaire mentioned above.
Reactions from parties concerned came immediately (Drost, Köhler, and Scheerer
(2007)). While the Association of German Banks, the head organization of the first pillar
comprising the private commercial banks, lauded the Commission and its questioning
of regional demarcation, the heads of the savings banks’ and cooperative banks’ umbrella
organizations insisted on the pro-competitive effects of the banks they represent. Even
the European Parliament dealt with the issue. On June 5, 2008, it almost unanimously
adopted a resolution based on a report by the Italian MPE Pittella, in which it supported
the Commission but also regretted that the Commission did not take “sufficient account
of the specificities of the strictly regulated banking sector and the importance of culture,
habits and languages in consumer choices and protection for financial products” (Euro-
pean Parliament (2008)). As for cooperation between banks, the European Parliament
emphasized the positive role of all banks for the local economy and for the endogenous
potential of regions. In the cooperative banking sector, this resolution was interpreted as
a total rout for the Commission (Profil (2008)).
e excitement about the Commission’s report has subsided since the summer of 2008.
e banking crisis and its dramatic consequences for the real economy completely domi-
nate public perception. In fact, savings banks and cooperative banks appear as pillars of
stability these days, providing liquidity to local and regional economies. eir position has
been considerably strengthened both economically and politically. Although this is not the
time to criticize them or question their conduct, nevertheless, the basic questions raised
by the European Commission deserve further attention: Does cooperation among savings
1 See the staff working paper for additional information on the details, including the legal status, of the regional
principle in Germany and other member states (European Commission, Directorate-General for Competition
(2007, 42/44-45)).

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banks and cooperative banks enhance or restrict effective competition in the banking
industry? And is regional demarcation in the savings and cooperative banking sectors a
device that furthers or hinders competition among banks?
In this paper we focus on the latter question, taking the regional principle applied in
the German savings and cooperative banking sectors as given. Tradition, a long-standing
consensus in the respective banking group, and – in the case of savings banks – even a
legal provision, all require these banks to limit their lending activities to customers in
their home markets. Savings and cooperative banks think of competing against banks
from the other two pillars of the German banking system, but not against banks from
the same pillar. A potential informational advantage (see Hakenes and Schnabel (2007))
from focusing on local and better-known customers may provide an economic reason for
regional demarcation, but we leave endogenization of the regional principle for future
research. Furthermore, there is a discussion in Germany about weakening the separation
of the three pillars by allowing mergers and acquisitions, e.g., between private commercial
and savings banks. But this questioning of the three-pillar structure itself was not in the
focus of the European Commission’s communication we refer to, and it would in fact pose
different questions and create a research topic of its own.
Conventional wisdom from microeconomics strongly suggests that restricting the inten-
sity of competition by staying out of a market will lead to a deterioration of aggregate
market performance, making customers worse off and banks in the aggregate better off.
But in our model we explicitly account for the atypical, nonstandard objective functions
of savings and cooperative banks, which are obliged to pursue objectives other than profit
maximization. Once this stylized fact is taken into account, the question arises whether
all banks symmetrically benefit from regional demarcation and how the different banks
are affected once regional demarcation is lifted. Using the industrial economics approach
to banking (see Freixas and Rochet (2007, chapter 3)) we consider two adjacent bank
duopolies with one private commercial bank operating in both markets and one savings or
cooperative bank present, but working separately, in each market. We compare the initial
situation with regional demarcation to the one without demarcation in which each of
the two savings or cooperative banks competes in both markets. Banks optimally choose
loan and deposit volumes. Because regional demarcation in Germany applies mainly to
lending activities, we present our results only for the banks’ loan business. For the sake of
completeness we also mention consequences for the deposit markets.
e paper is structured as follows: In section 2 we briefly present the related literature.
Section 3 contains our model and the derivation of our results. We discuss the role
of savings and cooperative banks’ atypical objective functions in section 4. Section 5
concludes.
2 Re vi e w of The li TeR aT u Re
Private commercial banks from the first pillar of the German banking industry often
argue that regional demarcation puts them at a disadvantage, because by not competing

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among their own banking groups, savings banks and cooperative banks might reserve
more strength for competing against the private commercial banks. Standard microeco-
nomic thinking in a static framework suggests an aggregate welfare loss, but implies that
overall, banks gain from the regional principle. When, for example, a savings bank in
one region refrains from competing for customers in another region because of the fact
that there is a savings bank present in this market, the intensity of oligopolistic competi-
tion in this other market is lower than it could be. However, we might conclude that
due to their higher concentration private commercial banks are also beneficiaries of the
regional principle and should therefore be careful in their lobbying for its abolishment.
But, as opposed to standard oligopoly theory, the banking firms in our framework are
asymmetric, because banks in the second and third pillars pursue objectives other than
pure profit maximization. We examine how this fact changes banks’ attitudes towards
regional demarcation.
We focus on a given number of banks, i.e., we do not address the issue of bank mergers
within or across pillars, and we examine the consequences of the fact that some banks
refrain from competing with each other. Regional demarcation looks like a (legal) region
cartel with the well-known consequences for market performance in a standard oligopoly
framework. However, in competition theory, models of workable and effective competi-
tion also indicate potentially welfare-enhancing effects of reducing competition among
smaller firms when they face a large, dominant competitor. But given the quite remarkable
market shares that savings and cooperative banks hold in many regional markets, it is not
convincing to defend regional demarcation this way. In Germany, for example, regional
demarcation rules for savings and cooperative banks are not based on § 3 of the German
Act against Restraints of Competition, which permits cartels of small and medium-sized
firms. In our opinion, the nonstandard objective functions of both savings and coopera-
tive banks constitute a more interesting issue, raising second thoughts on whether the
conventional wisdom from oligopoly theory applies for regional demarcation.
Somewhat related to our problem are the studies on foreign bank entry after a liberal-
ization of the banking market. Most articles investigate the entry of a new bank either
via acquisition of a domestic bank or via “greenfield investment”, and conclude that
competition intensity increases, prices decrease, and access to financial products improves.
Whether these changes have welfare-enhancing effects is by no means clear-cut, because
the related decrease in banks’ profits might mitigate their incentives to make neces-
sary investments for example in a profitable screening technology (see, e.g., Lehner and
Schnitzer (2008)). Banks in such a market entry setting probably differ in their informa-
tion about customers. For example, in Dell’Ariccia and Marquez (2004), domestic banks
enjoy an informational advantage and thus capture their borrowers. If there’s an increase
in competition, then domestic banks concentrate on their captive sectors where they serve
both good and risky customers, while foreign banks engage in sectors with less informa-
tion asymmetry and serve good customers by offering smaller interest rates.
ere are a few papers that deal with regional demarcation and the way savings and coop-
erative banks compete. Hempell investigates competition in German banking empirically
and finds less competitive behavior for cooperative banks and savings banks compared to

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private commercial banks (but she excludes the very largest banks). e author explains this
by pointing to regional demarcation, which excludes competition within two of the three
pillars of the industry (Hempell (2002, 32-33)). Hakenes and Schnabel (2007) confirm the
proposition that regional demarcation restricts competition. But these authors show that
this limitation may also have positive effects. Banks with a regional focus are able to estab-
lish closer relationships with their customers, thus creating benefits, e.g., from customer
loyalty, a homogeneous mentality, identification with the region and its economy, and so
on. is proximity to customers can be used to generate and extract information, especially
soft information. us, since information is crucial for loan supply to small and medium-
sized firms or private customers with little collateral, regionally oriented banks may be able
to serve clients that a bank which is operating nationally would refuse to serve because of
problems of asymmetric information. On balance, the net effect of regional demarcation
on social welfare is ambiguous (Hakenes and Schnabel (2007)).
In another paper, Hakenes and Schnabel show that when they invest local funds in local
projects, banks focused on a region are able to increase social welfare at least of that region
(Hakenes and Schnabel (2010)). e authors argue that such banks can help solve the
problem of capital drain from poorer to richer regions by offering better interest rates for
depositors. In accordance with their statutes, savings banks can implicitly subsidize local
loans by not pursuing profit maximization. Analogously, cooperative banks that follow
the principles of cooperative banking can grant privileged access to funds and loans for
their members. is beneficial role of savings and cooperative banks is only viable if there
is credible regional demarcation.
e ongoing discussion about reforming the German savings bank sector reflects these
issues. Regional demarcation is seen as fostering access to financial services and economic
growth in all regions, thereby enhancing social welfare. Because of their focus on profit
maximization, private commercial banks cannot deliver this result, since they concen-
trate on servicing prospering regions. Partially eliminating competition among banks
from different regions reduces competitive pressure between regions, which helps weaker
regions. However, the price is a suboptimal capital allocation between regions. Savings
banks are excluded from possibly beneficial capital transactions outside their home regions
and are restricted in their growth possibilities (Müller (2005)).
Regional demarcation is a phenomenon that appears in the savings and cooperative
banking sectors of several European countries. However, in some places the process of
privatizing savings banks went hand in hand with the abolition of regional demarcation
(for example, demarcation was eliminated in Italy in 1990, in Austria in 1979, and in
Spain in 1988). Other countries such as France maintained regional demarcation when
their savings banks were converted into cooperative banks (Brunner et al. (2004, 39-
41); Hakenes and Schnabel, (2010, 665)). In Italy, competition in the banking industry
increased after regional restrictions ended, but banking activities had been much more
limited by Italian regulation before 1990 than they are, for example, by regional demar-
cation in Germany (Carletti, Hakenes, and Schnabel (2005)). Carletti et al. note that
competition could possibly be intensified by scrapping the regional demarcation principle
in Germany. However, they remain skeptical about transfering Italian-style reforms and

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especially about the positive consequences of such reforms to the German banking market,
because Germany’s initial situation is very different (Carletti, Hakenes, and Schnabel
(2005, 47f.)).
Brunner et al. find empirical evidence that competition intensity in the German banking
sector is comparable to that in Italy or Spain, where regional demarcation has been elimi-
nated, and more intense than in France where it still exists (Brunner et al. (2004, 23)). e
question is whether getting rid of the regional principle intensifies competition (and which
banks would suffer or benefit from this change) or whether the pro-competitive effects are
somehow counterbalanced. Following reforms that affected savings and cooperative banks,
observers find evidence of higher profitability of banks (Brunner et al. (2004, 39-42))
and for Italy, Spain, and France, of an increase in market power (Engerer and Schrooten
(2004, 3)) that may be the result of mergers following the reforms.
From the U.S. market we have evidence that some banking products like deposits and
small business lending are “local in nature” (Hannan and Prager (2004, 1890)). As a
consequence, some banks operate in only one local area. (Such banks are called “single-
market banks”.) However, multimarket banks that operate in several local areas have
recently come into existence, especially after deregulation of regional restrictions. Hannan
and Prager show theoretically and empirically that multimarket banks, which offer the
same interest rate in all regions, on average offer a lower payment for deposits than do
regional banks, thus inducing these banks to reduce their deposit rates as well. As reasons
for the lower interest on deposits offered by multimarket banks, the authors mention
more market power due to their larger operation area, less efficiency because of disec-
onomies of scale or scope, and better access to alternative funds. In the context of our
paper, this reasoning indicates that banks with a regional focus improve their customers’
economic situation compared to banks with nationwide operations. is result supports
our findings.
Gehrig (1998) analyzes another critical point of integration, showing that opening the
banking market to foreign competitors also involves costs. Although integration may
intensify competition and thereby reduce banks’ oligopoly rents, it may also reduce banks’
incentives to screen their borrowers’ projects, which can lead to more risky loan portfo-
lios. en, necessary risk premia may even outweigh a decline in loan rates due to fierce
competition. In this case, eliminating regional competition by, for example, maintaining
regional demarcation, is beneficial. Gehrig identifies especially members of the European
Union as candidates for such costs of integration.
3 moDel
In a standard oligopoly framework we examine the impact of regional demarcation on
competition in banking. We pay special attention to the fact that savings and cooperative
banks pursue objectives that are different from those of private commercial banks. We
focus on the market structure effects and their consequences and deliberately leave out
informational aspects that can augment the effects we identify.

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3.1 Bas ic se t up
We consider two regional banking markets, i = 1, 2, adjacent to each other. ere are
a number n
0
of (large) private commercial banks operating in both markets simultane-
ously. In addition, there are n
si
savings banks and n
ci
cooperative banks in each market i.
According to the logic of regional demarcation, n
si
and n
ci
can take only the values of zero
and one, i.e., there can be no more than one savings bank and one cooperative bank in a
market. Furthermore, the regional principle requires that a savings bank and a cooperative
bank in market i serve loan demand only from this market. Customers from the other
market j, j∈ {1, 2}, j ≠ i, who show up at the bank will not be served.
To focus on the most basic setup, we assume n0 = 1, nci = 1 and nsi = 0, i.e., we
consider one private commercial bank operating in both markets, which we call bank 0,
and one savings or cooperative bank in each market, which we call bank c(1) in market 1
and c(2) in market 2, operating only in its home market. In total we have two adjacent
duopolies with bank 0 competing in both markets:
Figure 1: Banking Markets under Regional Demarcation
Market 1 Market 2
Bank 0
Bank c(1) Bank c(2)
e fact that in Figure 1 we represent bank 0 in market i smaller than bank c(i) reflects
the empirical observation that savings banks and cooperative banks in regional markets
often have similar or even larger market shares than do the private commercial banks
that operate in many regions simultaneously. For this reason we do not model bank 0 in
market i as a large or dominant bank.
Whenever there is no need to explicitly distinguish between the two savings or coopera-
tive banks, as is the case when we look at only one market under regional demarcation,
we simplify our notation and use the symbol c instead of c(1) or c(2). us, k ∈ {0, c}
denotes the two banks present in a market.
We use the intermediation approach from the industrial economics of banking (see Sealey
and Lindley (1977)) that dominates both theoretical and empirical analyses, and consider

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banks as firms receiving deposits and giving loans. Total loan volume in market i is
Li = L0
i + Lc
i, i.e., it comprises the loans L0
i originated by bank 0 and those loans Lc
i
granted by bank c to customers of market i. Each bank charges its borrowers an interest
rate rk
L. We assume that loans do not bear any project risk and therefore banks need not
care about the creditworthiness of their customers. I.e., we abstract from the fact that a
change in competition due to the abolition of regional demarcation influences a bank’s
loan portfolio and risk situation (see Gehrig (1998)). Banks may have different capabili-
ties in extracting information about their risky customers. ese differences could affect
savings and cooperative banks once regional demarcation is lifted and the banks enter new
markets. We further discuss this point in our conclusion.
In the deposit business we have in market i Di = D 0
i + Dc
i. e interest rate each
bank has to pay to its depositors is denoted by r
k
D
. Omitting bank- and markets-specific
subscripts and superscripts, a bank’s profit function is
π = rLL – rDD + rM – C(L, D), (1)
where M is the bank’s (positive or negative) position in the interbank market, earning
or paying an exogenously given market interest rate . is is a standard assumption used
in the literature. It can be motivated by the role of the central bank and its open market
operations and, in our case, by the small weight of the local or regional markets considered
relative to the whole interbank market. C(L, D) captures the operational costs of the bank
and includes as an additive term fixed costs – e.g., for branch offices and information
technology – which are a source of economies of scale. We assume the usual properties of
positive first derivatives and of second derivatives to ensure existence of solutions to the
banks’ maximization problems. We make no specific assumptions for the cross derivatives.
By using these cross derivatives our cost function may include a (sufficient) condition
for economies or diseconomies of scope between the bank’s loan business and its deposit
business. We need only assume that the cross derivatives are not strong enough to destroy
the convexity of the cost function. Since we are not interested in regulatory issues of the
Basel 1 and Basel 2 type, we can ignore the bank’s equity without loss of generality. Loans
are financed with funds from deposits and perhaps the interbank market. us, the bank’s
stylized balance sheet is given by
D = αD + L + M, (2)
where αD is the contribution to deposit insurance and the minimum reserve paid to the
central bank. Substituting (2) into (1) yields the simplified profit function
π = (rL – r)L + (r(1 – α) – rD)D – C(L, D). (3)
Interest margins in the loan business and the deposit business, loan and deposit volumes,
and operational costs determine a bank’s profit.
Since we analyze oligopolistic markets, the choice of decision variables – prices, i.e.,
interest rates, or quantities, i.e., loan and deposit volumes – matters for our results. Prac-

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titioners in the banking industry might claim that they maximize their objective func-
tions by setting interest rates for loans and deposits. However, we follow the majority in
the industrial economics literature on banking and use quantities as decision variables.
Schliephake and Kirstein (2010) show that in banking, if it is relatively costly to change
regulatory capital ex post, then a choice of regulatory capital followed by price competi-
tion in both the deposit and the loan markets is equivalent to quantity competition in
these markets. erefore, existence of Basel-type banking regulation allows us to transfer
the reasoning by Kreps and Scheinkman (1983), that capacity choice followed by price
competition is logically equivalent to quantity competition, to the banking industry. e
decisive capacity constraint cannot be found in building or renting office space and hiring
and training staff, but rather in the equity (regulatory) capital available for meeting the
regulatory requirements of a bank’s loan business. Given that a bank’s regulatory capital is
chosen ex ante and is costly to change, we feel vindicated in our view that it makes sense
to model banks as choosing loan and deposit volumes to maximize their objective func-
tions. Further, a brief glance at price competition suggests similar results.
In examining objective functions, we first state that private commercial banks can safely
be assumed to be interested only in profit maximization, using the profit function defined
in (3). However, the banks that belong in the other pillars of the banking system, which
we label by c or c(i) in our model, pursue objectives other than pure profit maximization.
Savings banks are obliged to improve social welfare, for example, by providing access to
affordable loans and deposits. Cooperative banks have to improve the economic situation
of their members. In its staff working paper, the European Commission acknowledged
this specific role of savings and cooperative banks: “Large shares of retail banking activity
in Member States such as Austria, Germany, France, Italy and Spain are undertaken by
cooperative banks and savings banks. Many of these banks have social objectives, including
widening access to finance for consumers and SMEs, which are likely to create a different
set of profit incentives to shareholder-owned private banks” (European Commission,
Directorate-General for Competition (2007, 24)).
ere are several different ways to model nonprofit objectives. Examples can be found
in studies on mixed oligopolies that analyze competition between profit maximizing and
non-profit-maximizing (public) firms (Merrill and Schneider (1966); Rees (1984); Cremer,
Marchand, and isse (1989); De Fraja and Delbono (1989)). Often, such nonprofit-
maximizing firms are modeled as focusing on social welfare consisting of consumer and
producer surplus (Bárcena-Ruiz (2007, 265-266)) or at least as taking consumer surplus
into account (Welzel (1996)). In the area of banking, Smith (1984) considers a credit
union that maximizes service to its members subject to a zero-profit constraint, where
service is measured by the interest rate spread credit union members gain by banking
at the credit union instead of going to a private commercial bank. Barros and Modesto
(1999) model a public bank that apart from operating earnings, maximizes its volume
of loans and deposits, valued at their opportunity costs. Pursuing this objective function
will increase the supply of loans and the demand for deposits. e same holds true for an
approach suggested by Neumann and Reichel (2006) and Neumann, Reichel, and Weigand
(2008). ese authors assume that nonprofit banks determine their output such that their
operating earnings equal zero.

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e view that savings and cooperative banks produce higher loan and deposit volumes
than do private commercial banks is in line with Lakdawalla and Philipson’s (2006) theory
of nonprofit firms, which they treat as firms willing to forgo profits in exchange for higher
output. erefore, we model the banks from the second and the third pillars as consid-
ering their earnings on the one hand and output levels on the other. To keep matters
simple, we disregard the detailed differences between a savings bank and a cooperative
bank. In fact, we treat them as identical.
Concerning the objectives of nonprofit banks, we modify the approach of Barros and
Modesto (1999) and assume that those banks labeled by c and c(i), which could be either
savings or cooperative banks, recognize the volume of loans and of deposits in their objec-
tive functions. Omitting bank- and markets-specific subscripts and superscripts, we can
express the profit function such banks maximize as
π = (rL – r)L + (r(1 – α) – rD)D + θLrL + θD r(1 – α)D – C(L, D). (4)
We suggest that in our context, the parameters θL and θD in the third and fourth terms
can be interpreted as the additional (marginal) value a savings or cooperative bank realizes
when attending to its social duty and providing access to loans and deposits2. We include
r and r(1 – α) to reflect the opportunity costs of such behavior. To simplify the termi-
nology, from now on we speak of a cooperative bank when addressing a bank c or c(i).
3.2 eq uil iBr ium un d er re g io n al de mar c atio n
Our first step is to analyze the two markets separately. e private commercial bank 0
is operating in both markets, while the activities of banks c(i) and c(j) are restricted by
regional demarcation to either market i or market j. us, in each market competition is
characterized by a mixed duopoly. We assume that both cooperative banks are identical
and restrict our analysis to market i.
Inverse demand functions for loans and inverse supply functions for deposits in market
are given by
(r0
L)i = a – L0
i – b(Li
c(i)
+ Li
c(j)) and (rc
L)i = a – (Li
c(i)
+ Li
c(j)) – bL0
i (5)
(r0
D)i = e + D0
i + f(Di
c(i)
+ Di
c(j)) and (rc
D)i = e + (Di
c(i)
+ Di
c(j)) + fD0
i,
in which b, f ∈ [0; 1] represents the degree of product differentiation. If b, f = 1, then
loans or deposits offered by a private commercial bank do not differ from those offered
by a cooperative bank. With b, f < 1, customers value banking products differently,
depending on whether they are sold by bank 0 or by bank c(i). Differences in customer
valuation can arise, e.g., from customer proximity, emotional attachment or loyalty to one
2 In Barros and Modesto (1999), the parameters θL and θD represent weights for the revenues from loans and de-
posits that are chosen by government for regulatory reasons.

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bank type or another, or a different level of service and advice surrounding the product.
However, customers do not distinguish between products offered by the cooperative
banks. is is a simplifying assumption reflecting the fact that customers primarily value
the cooperative idea. If customers had a personal relationship to “their” cooperative bank,
we would have to introduce different weights for different banks even within the coop-
erative sector. For later use we include loan and deposit volumes of the cooperative bank
c(j) in market i in (5). At this stage, the regional demarcation principle implies that these
values have to be set equal to zero in the decision problems. Later, when we look at the
equilibrium without regional demarcation, this restriction will be dropped.
Bank 0’s maximization problem is
max
L, D
π0 =
(
(r0
L)i – r
)
Li
0 +
(
r(1 – α) – (r0
D)i
)
D0
i (6)
+
(
(r0
L)j – r
)
Lj
0 +
(
r(1 – α) – (r0
D)j
)
D0
j – C(Li
0, Lj
0, Di
0, Dj
0)
s.t. Li
c(j) = Lj
c(i) = 0, Di
c(j) = Dj
c(i) = 0.
e private commercial bank maximizes its combined profit from both the markets it
serves. e constraints represent the principle of regional demarcation. Using (4) we get
for the cooperative bank in market i
max
L, D
πc(i) =
(
(rc
L)i – r
)
Li
c(i) +
(
r(1 – α) – (rc
D)i
)
Dc
i
(i)
(7)
+
(
(rc
L)j – r
)
Lj
c(i) +
(
r(1 – α) – (rc
D)j
)
Dj
c(i)
+ θLr(Li
c(i) + Lj
c(i)) + θDr (1 – α) (Di
c(i) + Dj
c(i))
– C(Li
c(i), Lj
c(i), Di
c(i), Dj
c(i))
s.t. Li
c(j) = Lj
c(i) = 0, Di
c(j) = Dj
c(i) = 0,
where again the constraints ensure that the regional principle holds. We use the same cost
function C(·) in (6) and (7). Doing so reflects the stylized fact that despite being small
compared to private commercial banks, cooperative banks (and savings banks) cooperate
in their network and are thus able to produce with the same technology as a large bank.
However, this assumption is not crucial for our results.
Maximization with respect to loan volume and solving the first-order condition leads to
reaction functions in market i
Li
0(Li
c(i)) =
1
_
2
(
a – r – ∂ C
___
∂Li
0
– bLi
c(i)
)
(8)
for the private commercial bank and
Li
c(i)(Li
0) =
1
_
2
(
a – r – ∂C
____
∂Li
c(i)
– bL0
i + θLr
)
(9)

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for the cooperative bank, where ∂C/∂Li
k are the marginal operational costs for loans of
bank k. Note the last term in (9): e higher the output orientation in the cooperative
bank’s loan business, i.e., the higher θ
L
, the higher will be its loan volume for a given loan
volume of the private commercial bank.
Figure 2: Best-response Functions in a Loan Market with Regional Demarcation
Li
c(i)
Li
c(i)(Li
0; θL
> 0)
Li
c(i)(Li
0; θL
= 0)
Li
0
In fact, bank c’s interest in output in addition to profit works like a commitment to more
aggressive behavior in the loan market, implying a rightward shift of the cooperative
bank’s reaction curve. Figure 2 depicts this effect for constant marginal costs and b = 1.
For a θL > 0 bank c(i) sells more loans and bank 0 sells less.
Solving the best-response functions (8) and (9) for the Cournot-Nash equilibrium in loan
market i leads to
Li
0 = 1
____
4 – b2
[
(2 – b)(a – r) – 2 ∂ C
___
∂Li
0
+ b ∂C
____
∂Li
c(i)
– bθLr
]
(10)
Li
c(i) = 1
____
4 – b2
[
(2 – b)(a – r) – 2 ∂C
____
∂Li
c(i)
+ b ∂C
___
∂Li
0
+ 2θLr
]
,
from which we can calculate equilibrium interest rates
(r0
L)i = 1
____
4 – b2
[
(2 – b)a + (2 – b)(1 + b)r + (2 – b2)
∂C
___
∂Li
0
+ b ∂C
____
∂Li
c(i)
– bθLr
]
(11)
(rL
c(i))i = 1
____
4 – b2
[
(2 – b)a + (2 – b)(1 + b)r + (2 – b2)
∂C
____
∂Li
c(i)
+ b ∂C
___
∂Li
0
– (2 – b2)θLr
]
.
If b = 0, then customers perceive loans of the two banks as completely different, nonsub-
stitutable products, and both banks produce their monopoly loan volume. However, even

S. RAAB/P. WELZEL
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132
then the cooperative bank will have a loan volume θ
L
r/2 above the private commercial
bank’s loan volume for the benchmark case of identical marginal costs of lending, and it
will charge, by the same token, a lower interest rate. When customers perceive loans as
being homogeneous (b = 1), bank c’s loan volume will be higher by θLr.
In general, we find that the loan volume L
i
c(i)
sold by the cooperative bank under regional
demarcation is above the volume Li
0 of the private commercial bank, if and only if
∂C
____
∂Li
c(i)
– θLr < ∂C
___
∂Li
0
, (12)
i.e., as long as the difference between the cooperative bank’s marginal operational costs
in the loan business and its marginal valuation of its nonprofit objective is smaller than
the marginal costs of the private commercial bank. e fact that the cooperative bank
values loan quantity per se makes it more aggressive in the loan market and implies a
shift of best-response functions and market shares, as indicated in Figure 2. Condition
(12) can hold even if the cooperative bank has a disadvantage in terms of marginal costs.
Its commitment to the nonprofit objective offsets a competitive advantage of the private
commercial bank. Our solution is in line with that of Neumann and Reichel, although
they assume that the marginal costs of a cooperative or savings bank must exceed those
of the private commercial bank, if commercial banks are to stay in the market (Neumann
and Reichel (2006, 255f.)).
Technologies and economies of scale and scope are clearly issues that we wish to discuss
at this point. We refrain from assuming that the marginal operational costs of loans
be constant or identical. For bank 0 these costs also depend on the level of business
in market j ≠ i. Although economies of scale arising from fixed costs will not affect
(12), we can imagine bank 0 enjoying lower marginal costs to an extent that leads to
a violation of (12). Furthermore, under economies of scope between the loan business
and the deposit business, a higher total deposit volume from both markets could lower
the marginal cost of lending. Whether or not cooperative or savings banks have higher
marginal costs than do private commercial banks is, in the end, an empirical question,
and there is no theoretical or intuitive prediction of an answer in one direction or the
other. Certainly, many of the cost differences between the bank types considered are
probably related to fixed costs and therefore have no relevance for (12). However, because
of their regional focus, savings and cooperative banks enjoy an informational advantage
over private commercial banks that enforces (12) via lower lending costs. For economies
of scope, we find it hard to believe that the difference in deposit volumes between bank 0
and bank c(i) can lead to a significant cost advantage for bank 0 in the loan business. All
facts considered, condition (12) seems to be in good shape. Under normal circumstances
we can expect it to hold.
When we examine the interest rates borrowers pay for their loans, we find that if (12) holds,
then as long as loans are considered differentiated products (b < 1) the loan rate at the
cooperative bank c(i) will be lower than the rate at the private commercial bank. For b = 1,
i.e., homogeneous products, interest rates for loans are identical at both banks.

BANKING
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When we perform an analogous analysis for competition in the deposit market, we arrive
at similar conclusions: Cooperative and savings banks in equilibrium have a higher volume
of deposits in a market compared to a private commercial bank, if and only if
∂C
____
∂Di
c(i)
– θDr(1 – α) < ∂C
___
∂Di
0
(13)
holds. Again, the commitment to output that is reflected in the objective function could
even compensate a cost disadvantage of bank c(i). If customers perceive deposits as
differentiated products (f < 1), then (13) implies that the private commercial bank
pays a lower interest on deposits than the cooperative bank. For homogeneous deposits
(f = 1) interest rates are the same. Hannan and Prager obtain similar results in their
analysis of single- and multi-market banks in the U.S. ey find that banks serving several
markets grant lower deposit rates than do those banks that operate only locally (Hannan
and Prager (2004, 1891)).
3.3 eq uil iBr ium wit hou t regi o na l dema rcat i on
We now study a different framework in which both the commercial bank 0 and the two
cooperative banks c(1) and c(2) are allowed to offer their products in both markets.
ere is no longer regional demarcation preventing bank c(j) from competing in market
i. Instead, we have the situation depicted in Figure 3.
Figure 3: Banking Markets without Regional Demarcation
Market 1 Market 2
Bank 0
Bank c(1)
Bank c(2)
We first aggregate loan demand and deposit supply of the two adjacent markets. us, we
replace the demand and supply conditions in (5) by
r0
L = a –
1
_
2
L0 –
b
_
2
(Lc(i) + Lc(j)) and rc
L = a –
1
_
2
(Lc(i) + Lc(j)) –
b
_
2
L0
(14)
r0
D = e +
1
_
2
D0 +
f
_
2
(Dc(i) + Dc(j)) and rc
D = e +
1
_
2
(D c(i) + Dc(j)) +
f
_
2
D0.

S. RAAB/P. WELZEL
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134
Customers perceive products of the two cooperative banks c(i) and c(j) as perfect substi-
tutes, i.e., there is only product differentiation between the private commercial bank
and the two cooperative banks. Arbitrage prevents the banks from price-discriminating
between the two markets.
Our results are now driven by both the liberalization of competition and the nonprofit
orientation of two of the three competitors. We analyze in detail the output orientation’s,
i.e., the θ’s, influence in section 4. Using (14) to describe demand and supply conditions
and dropping the constraint of regional demarcation, the private commercial bank’s profit
maximization problem now implies for its loan business in both markets that
L0(Lc(i), Lc(j)) = a – r –
∂C
___
∂L0
–
b
_
2
(Lc(i) + Lc(j)).
(15)
For cooperative bank c(i) we get
Lc(i)(Lc(j), L0) = a – r – ∂C
____
∂Lc(i)
–
1
_
2
Lc(j) –
b
_
2
L0 + θLr,
(16)
and analogously for bank c(j). Solving for the equilibrium in the aggregated loan market
with one profit-maximizing and two nonprofit banks yields the following loan volumes:
L0 = 1
____
3 – b2
[
(3 – 2b)(a – r) – 3
∂C
___
∂L0
+ b
(
∂C
____
∂Lc(i)
+ ∂C
____
∂Lc(j)
)
– 2bθLr
]
(17)
Lc(i) = 1
____
3 – b2
[
(2
–
b)(a
–
r)
–
(4
–
b2)
∂C
____
∂Lc(i)
+ (2 – b2) ∂C
____
∂Lc(j)
+ b
∂C
___
∂L0
+ 2θLr
]
Lc(j) = 1
____
3 – b2
[
(2
–
b)(a
–
r)
–
(4
–
b2)
∂C
____
∂Lc(j)
+ (2 – b2) ∂C
____
∂Lc(i)
+ b
∂C
___
∂L0
+ 2θLr
]
.
Since we model the two cooperative banks c(i) and c(j) symmetrically, L
c(i)
will equal
Lc(j) in equilibrium, leading to
Lc(i) = 1
____
3 – b2
[
(2
–
b)(a
–
r)
–
2
∂C
____
∂Lc(i)
+ b
∂C
___
∂L0
+ 2θLr
]
.
(18)
We can calculate from (17) and (14) the equilibrium interest rates r0
L and rc
L.
As before, we are interested in a cooperative bank’s share of the market in relation to the
private commercial bank’s share. It turns out that each cooperative bank offers a greater
loan volume, i.e., Lc(i) > L0, if and only if
2(1 +
b)
(
a
–
r
–
∂C
____
∂Lc(i)
+ θLr
)
– (3 + b)
(
a
–
r –
∂C
___
∂L0
)
> 0. (19)
e term in the first large bracket is bank c(i)’s monopoly output in the aggregated
market. By the same token, the second large bracket equals bank 0’s monopoly output.
For the cooperative bank’s monopoly output to exceed that of the commercial bank and
therefore (19) to hold, a sufficient condition is

BANKING
sbr 63 April 2011 120144 135
∂C
____
∂Lc(i)
– θLr <
∂C
___
∂L0
. (20)
is condition is basically the same as (12), which we derived under regional demarcation.
e marginal costs of the cooperative bank may now be higher because of a larger loan
volume. However, if a larger market simplifies the attraction of deposits, then economies
of scope may diminish the cooperative bank’s marginal loan costs. We also note the fact
that a cooperative bank not only enjoys a larger market, but also faces more intensified
competition due to the presence of the other cooperative bank in its home market, which
will limit the increase in volume after the abolishment of regional demarcation.
For equilibrium interest rates, we again find that cooperative banks charge a loan rate
r
c
L
< r
0
L
as long as (20) holds and loans are perceived as differentiated (b < 1). So again,
the existence of output orientation, i.e., a θL > 0, makes the cooperative bank more
aggressive. When we look at deposits, aggregating deposit supply functions, using arbi-
trage conditions and solving the maximization problems leads us to an equilibrium in the
deposit market, under which each cooperative bank collects more deposits than the private
commercial bank, if and only if
∂C
____
∂Dc(i)
– θDr(1 – α) <
∂C
___
∂D0
, (21)
and pays a higher interest on deposits as long as deposits are differentiated (f < 1).
3.4 co mpar iso n of the an aly si s wi th a nd w ith o ut reg io n al de m ar c atio n
We can now compare the equilibrium under regional demarcation to the one without
regional demarcation. Since we want to know whether regional demarcation reduces the
intensity of competition as the European Commission had suspected, we focus on loan
volumes and profit levels. Let L
reg
k
denote bank k’s total loan volume from one or, if
relevant, both markets in the equilibrium under regional demarcation and let L
nreg
k
denote
total loan volume without regional demarcation. When we compare equilibrium values
for a cooperative bank c(i), we find that the bank hands out less loans under regional
demarcation, i.e., L
reg
c(i)
= L
i
c(i) < L
nreg
c(i)
, if
(3 – b2)
[
(2 – b)(a – r) – 2 ∂C
___
L
i
c(i)
+ b
∂C
___
∂L
i
0
+ 2θLr
]
(22)
< (4 – b2)
[
(2 – b)(a – r) – 2 ∂C
___
Lc(i)
+ b
∂C
___
∂L
0
+ 2θLr
]
.
3 – b
2
is positive and smaller than 4 – b
2
. Condition (22) then hinges on the signs and
relative magnitudes of the two terms in squared brackets. If the cooperative bank sells
a strictly positive loan volume both under regional demarcation and without regional
demarcation, then both squared brackets are strictly positive. e change in marginal costs
between the two regimes matters, since for both bank c(i) and bank 0 on the left-hand
side we find the marginal costs related to the loan volume sold in market i only, but on the
right-hand side the marginal costs relate to the total loan volume sold by a bank in both

S. RAAB/P. WELZEL
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136
markets. As benchmark we assume that the marginal costs of lending for bank c(i) remain
unchanged, i.e., ∂C/∂ L
i
c(i)
= ∂C/∂L
c(i)
. For the private commercial bank 0, the analo-
gous assumption ∂C/ ∂L
i
0
= ∂C/∂L
0
is natural, given that this bank serves both markets
under both regimes, and in a realistic scenario will also be present in a large number of
other local markets. Under these assumptions, the two squared brackets are identical, and
we conclude that the cooperative bank will have a higher loan volume without regional
demarcation compared to the regime under regional demarcation.
We want to develop a clear understanding of what will happen if marginal costs are not
identical across regimes. If bank c(i) in the regime without regional demarcation offers
loans in the adjacent market j, then it might suffer from informational disadvantages and
customers who still need to be convinced to come to bank c(i). is lack of confidence
could amount to an increase in the marginal costs of lending, implying ∂C/∂ L
i
c(i) <
∂C/∂Lc(i). As long as this increase is not too strong, it will not alter our result. If, on the
other hand, serving a second market leads to a decrease in the marginal costs of loans at
the cooperative bank, then our result is strengthened.
Since we now know that each cooperative bank extends its loan supply when the regional
demarcation principle is abolished, we look at bank 0. e private commercial bank will
sell a higher loan volume under regional demarcation, i.e., L
reg
0
> L
nreg
0
, if, in the bench-
mark case of identical marginal costs across regimes considered before
2b
(
a – r – ∂C
____
∂Lc(i)
+ θLr
)
– b2
(
a – r –
∂C
___
∂L
0
)
> 0. (23)
e term in the first bracket displays two times bank c(i)’s monopoly output in market i.
e second bracket equals twice bank 0’s monopoly output in that market. If the marginal
costs of both banks were identical, then bank c(i) would sell a higher monopoly output than
bank 0 as long as it pursued a nonprofit objective (θ
L
> 0), and (23) would hold. A cost
disadvantage of the cooperative bank weakens this result, and a stronger nonprofit orien-
tation and less differentiation strengthens it. If loans are perfectly differentiated (b = 0),
then bank 0 sells the same loan volume under both regimes.
Finally, we compare the total loan volume in both markets without regional demarcation
to a situation with regional demarcation. We know already that cooperative banks will
increase loan volumes and the private commercial bank will decrease its loan volume
once regional demarcation is abolished. Again we assume identical marginal costs across
regimes. e expansionary effect at nonprofit banks dominates the contractionary effect
at the private commercial bank, i.e., Lnreg > Lreg, if
(2 – b)
[
(2 – b)(a – r) – 2 ∂C
____
∂Lc(i)
+ b
∂C
___
∂L
0
+ 2θLr
]
> 0. (24)
e term in squared brackets is the loan volume a cooperative bank sells in the two
markets if there is no regional demarcation. I.e., as long as abolishing regional demarca-
tion does not push the nonprofit banks out of the loan markets (which we do not expect,

BANKING
sbr 63 April 2011 120144 137
given that they increase their loan business once demarcation is abolished), then total loan
volume will be higher without demarcation.
Similar comparisons for profit levels show that once regional demarcation is abolished,
the private commercial bank’s profits from its loan business will decrease under plausible
conditions. When we look at cooperative banks and evaluate their objective functions
(inclusive of the nonprofit objective as introduced in (4)), we find that if there is no
longer regional demarcation, then as long as loan products are sufficiently homogeneous
the nonprofit banks will benefit.
Our results indicate that abolishing the regional demarcation principle leads to a higher
supply of loans and to lower interest rates for loans. is conclusion supports the Euro-
pean Commission’s concerns about regional demarcation and the proposition that the
(self-) restriction to regional markets limits competition and therefore loan supply. But
in stark contrast to the claim of some private commercial banks and their lobbyists, this
distortion is not beneficial to cooperative or savings banks, but it is favorable for private
commercial banks because it effectively shields first-pillar banks from intensified compe-
tition. To a considerable extent this result is driven by the nonprofit orientation of the
banks in the second and third pillar.
4 The Role of ouT puT oR i enTaT i on
In this section we study more closely the role the parameters θL and θD play, since
these two parameters are the distinctive characteristics of bank c(i)’s objective function,
capturing the extend of its nonprofit orientation. ese parameters contribute to a more
aggressive behavior of such a bank and make it more likely that a private commercial bank
benefits from the regional principle (see (23)).
Our first step is to compare the previous situation we analyzed to a world in which all
banks are private commercial banks. We use this comparison to show which adjustments
are due to market integration when regional demarcation is abolished, and which of them
refer to the existence of nonprofit banks. Doing so clarifies the influence of θ
L
and θ
D
on
our results.
To investigate competition only between profit-maximizing banks, we set θL and θD equal
to zero. We call this situation “pure competition”, and label as “mixed” a market in which
commercial and cooperative banks compete. e pure situation with regional demarca-
tion is depicted in Figure 2. In a symmetric equilibrium, if marginal costs are identical
then both commercial banks offer the same amount of loans and deposits. e quantities
are smaller than the ones a nonprofit bank would offer. us, private commercial bank
01 offers the following credit supply, depending on its own marginal costs and those of
its competitor 02:
L
i
01 = 1
____
4 – b2
[
(2 – b)(a – r) – 2
∂C
___
∂L
i
01
+ b
∂C
___
∂L
i
02
]
. (25)

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138
If both commercial banks are identical, then the total loan supply in market i sums up
to
L
i
pure = 2
____
2 + b
[
a – r –
∂C
___
∂L
i
0
]
. (26)
is loan amount is smaller than the volume of loans offered in a mixed market, as long
as condition (12) holds. e existence of a nonprofit competitor, i.e., a strictly positive
value of θL, then raises the credit supply in separated markets. Condition (13) suggests an
analogous conclusion for total deposit supply.
To identify the effect the integration of markets has on loan and deposit quantities, we
consider an aggregated market where three private commercial banks compete. In this
case, bank 01 offers a loan quantity of
L
01 = 1
_________
(2 – b)(1 + b)
[
(2 – b)(a – r) – (2 + b)
∂C
___
∂L
01
+ b
(
∂C
___
∂L
02
+
∂C
___
∂L
03
) ]
. (27)
Again, the three banks serve the market equally if marginal costs are equal. Hence, the
total loan volume in the integrated market is
Lpure = 3
____
1 + b
[
a – b –
∂C
___
∂L
0
]
, (28)
which is less than a mixed oligopoly would offer if the following condition holds:
2(1 + b)(2 – b)
[
a – r –
∂C
___
∂L
c
+ θLr
]
– (3 + b)(2 – b)
[
a – r –
∂C
___
∂L
0
]
> 0. (29)
e term in the first squared brackets is the monopoly output of a cooperative bank, the
one in the second squared brackets displays the monopoly output of a private commercial
bank. As mentioned above, we would expect a nonprofit bank to offer more if θ
L
is posi-
tive, and that therefore, (29) would hold. is result shows again that credit supply in a
mixed (integrated) market exceeds that of a pure market and θL raises market outcomes.
Comparing the situations with and without regional demarcation under pure competi-
tion shows that the integration of the adjacent markets leads to a reduction of the loan
volume of a single bank because of more intense competition. At the same time, the total
loan supply in the aggregated market increases due to the additional competitor. is
result is standard in oligopoly theory. In the analysis of mixed markets, the outcomes for
the commercial bank turn out to be similar. When regional demarcation is abolished, the
credit supply of the commercial bank decreases and the total loan supply increases. But
here, the loan quantity the cooperative banks offer increases when markets are integrated.
erefore, to attain the same increase in total credit supply, the commercial bank’s loan
quantity must further decrease. is result strengthens the finding that a private commer-

BANKING
sbr 63 April 2011 120144 139
cial bank is shielded from fierce competition by the existence of regional demarcation, and
the higher is θL, the more relevant is this finding. We expect similar results for the deposit
business. e case of θD = 0 reflects the idea that a cooperative bank has a nonprofit
motive only with respect to loans, but not for deposits, which is certainly realistic.
So far, we have given each nonprofit bank the same weights θL and θD for loans and
deposits in its objective function, no matter whether it operates in one or two markets.
However, when a nonprofit bank enters a new market, it is not deeply rooted in this region
or emotionally related to the new customers living there. is lack of customer proximity
suggests lower values of θ
L
and θ
D
in the adjacent region, which becomes accessible once
regional demarcation is lifted. If the nonprofit bank acts like a commercial bank in its
nondomestic market, then θ
L
and θ
D
for this market equal zero. We extend our notation
to deal with this different treatment of markets. We denote the additional marginal value
attached in a bank’s objective function to loans and deposits to customers of the home
market by θ
L
H
and θ
D
H
, and those related to customers in the adjacent market by θ
L
F
and
θ
D
F . As long as regional demarcation exists, these new parameters make no difference,
because nonprofit banks are active only in their home markets, i.e., only θ
L
H
and θ
D
H
are
relevant. When markets are integrated, each cooperative bank deals with customers from
its home market and acquires new customers from the adjacent market. A cooperative
bank allocates its activities between its traditional home market and the newly accessible
market according to the marginal valuations in its objective function. Our calculations
show that the higher are θ
L
H
and θ
D
H
, the more loans a cooperative bank offers and the
more deposits it takes in its initial market. Similarly, the higher are θ
L
F and θ
D
F , the more
business it does with customers from the adjacent market. e competing banks react with
a decrease in quantities. e cooperative bank from market 2 enters the other cooperative
bank’s home market 1 with a loan and deposit quantity decreasing in θ
L
H
and θ
D
H
. e
private commercial bank reduces its loan and deposit quantities in market 1. Conversely,
a high θ
L
F
and θ
D
F
decrease the loan and deposit quantities the cooperative bank 1 and the
commercial bank offer in market 1.
In the most realistic and relevant case of θ
L
H > θ
D
F > 0, the cooperative bank already estab-
lished in a market offers more loans to customers in this market than does the entering
cooperative bank from the adjacent market. Similar to our earlier analysis, if products
are differentiated and the monopoly output of the cooperative bank exceeds that of the
private commercial bank, then the loan quantity of the established cooperative bank is
greater than that of the private commercial bank. Whether the cooperative bank from the
adjacent market enters the market with a greater loan quantity than the commercial bank
depends on the magnitude of θ
L
F and monopoly outputs.
If a cooperative bank cares only about customers in its traditional market, then θ
L
F
and θ
D
F
equal zero, and a cooperative bank will act like a commercial bank in the adjacent market
once it has the opportunity to serve it. In this case, the cooperative bank offers a higher
loan volume compared to its competitors in its initial market and becomes the dominant
bank in this market. erefore, the market-specific valuation has a separating effect and
mitigates the consequences the abolition of regional demarcation has.

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140
We could also imagine that eliminating regional borders would induce a cooperative bank
(or a savings bank) to behave more like a private commercial bank. In the extreme case,
output orientation would completely disappear, i.e., θ
L
H = θ
L
F = 0. Comparing loan
volumes with regional demarcation and output orientation (10) to volumes in a situa-
tion without regional demarcation and only profit-maximizing banks ((17) with θ
L
= 0)
leads to following results: the cooperative banks increase their loan volumes when regional
demarcation is abolished, as long as their loan volumes without output orientation exceed
2θ
L
r. is term displays (3 – b
2
) times the effect output orientation has on a cooperative
bank’s quantity. I.e., if the loan volume offered without output orientation is above the
additional quantity effect that the nonprofit objective would have, then each cooperative
bank increases its loan supply if markets are integrated. Again, this increase comes at
the expense of the commercial bank, which must reduce its loan volume under similar
conditions. But we can show that if the stated quantity condition is fulfilled, then the
total loan amount again increases when abolishing regional demarcation. Although these
results are similar to the original setting, the magnitude differs. When integrating markets,
the increase in cooperatives’ loan volumes is smaller without quantity orientation. We
conclude that the commercial bank is squeezed less than in the original setting, because
cooperative banks behave less aggressively once regional demarcation is abolished.
5 co nclus ion
In a widespread report on retail banking issued in 2007, the European Commission
expressed its concerns about cooperation in the savings banks and cooperative banks
sectors of the financial services industries in several member states. From the Commission’s
point of view, this close cooperation might damage effective competition. e report and
the ensuing public discussion motivated us to analyze in more detail one specific form
of cooperation, the principle of regional demarcation followed among savings banks and
cooperative banks in a number of member states.
Applying the industrial economics approach to the microeconomics of banking, we model
two adjacent markets in which one private commercial bank serves both markets and
initially competes in each market with a savings or cooperative bank that focuses on this
market. We contrast this setup under regional demarcation with an alternative scenario
in which each of the savings or cooperative banks is present in both markets, i.e., the
private commercial bank faces two competitors in each market and the two savings or
cooperative banks compete against each other. We model banks as traditional financial
intermediaries, taking deposits and giving loans. Since by statute or by tradition savings
and cooperative banks typically also pursue nonprofit objectives, we apply an idea from
the theory of nonprofit firms and capture these banks’ inclination to further social welfare
or the economic well-being of members by including loan and deposit volumes in their
objective functions. Doing so enables us to also determine to what extent our results
depend on the nonprofit orientation.
We first point out that the nonprofit objective makes a savings or cooperative bank more
aggressive in quantity competition. is insight aligns perfectly with many well-accepted

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results from oligopoly theory. As a consequence, savings and cooperative banks provide a
higher loan volume (at a lower interest rate) and take more deposits (at a higher interest
rate) than does the private commercial bank they compete with. is result holds both
with and without regional demarcation. e fact that there are banks in the loan and
deposit markets that pursue a nonprofit objective improves market performance, in the
sense of leading to higher volumes, and increases effective competition. When we compare
the situation without regional demarcation to the one with regional demarcation, we
find that once regional demarcation is abolished, each savings or cooperative bank has a
higher loan volume and the private commercial bank has a lower loan volume. And, prob-
ably most important from the European Commission’s point of view, total loan volume
will be higher without regional demarcation. e private commercial bank may suffer a
reduction in profits, but savings or cooperative banks do better when regional demarca-
tion is eliminated. us, lifting the regional principle benefits borrowers and the banks
in the second and third pillars of the German banking system, but has a negative effect
on private commercial banks. e nonprofit orientation of cooperative banks and savings
banks increases these effects of market integration.
erefore, we conclude that our analysis supports the European Commission’s point
to some extent, by verifying that regional demarcation impairs market performance in
banking. However, representatives and lobbyists of private commercial banks are mistaken
when they claim that they suffer from the fact that savings banks do not compete with
savings banks and cooperative banks do not compete with cooperative banks. In fact,
private commercial banks are shielded by regional demarcation from competition by
savings or cooperative banks, banks which compete the more aggressively the more they
pursue nonprofit objectives. And, no matter whether we have regional demarcation or not,
savings and cooperative banks improve market performance by intensifying competition
through their atypical objective functions.
Our analysis undoubtedly excludes a number of interesting aspects, some of which we
plan to address in the future. One important area for further discussion is the specification
of the stylized nonprofit objective function, particularly the weights attached to volumes
of loans and deposits. In this paper we have already considered a situation in which,
once regional demarcation is abolished, a savings or cooperative bank aims its nonprofit
objectives towards customers in its traditional home market far more intensively than
it does towards new customers. If the nonprofit objective is adopted only for the home
market, doing so separates markets even if regional demarcation is abolished. e effect
arising from nonprofit orientation will be mitigated, but if weights for the home market
are substantial, then our results will hold. We also expect our results to be robust against
different weights for loans and deposits, e.g., expressing the idea that savings and coop-
erative banks care more about higher loan volumes than about higher deposit volumes.
Furthermore, regional demarcation is exogenously given in our model. In Germany, for
example, it is a voluntary, strategic choice in the cooperative banking sector, and a statu-
tory prescribed by the law governing savings banks. We could endogenize the decision for
or against regional demarcation by leaving it to the banks themselves to decide whether
or not to operate in an adjacent market.

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As for the choice of decision variables, we are very comfortable with the reasoning by
Schliephake and Kirstein (2010), which provides a sound basis for looking at quantity
competition. After taking a first look at price competition, we conclude that similar results
would arise under this alternative mode of competition.
Finally, in the tradition of the industrial economics approach to banking, there is no
uncertainty in our model. However, we do wonder how our thinking about regional
demarcation might change if some form of credit risk were included and loans to
customers beyond the home market were riskier because the savings and cooperative banks
no longer enjoyed the informational advantage they now hold in their home markets. On
the one hand, the regional principle prevents savings and cooperative banks from enjoying
more diversified loan portfolios, but on the other hand it protects them from selling loans
in markets where they do not properly understand the risks. is is an important issue
for future research.
In our analysis we take the distinction between two banking groups – one with pure
profit orientation and no regional demarcation, another with a nonprofit objective and
regional demarcation – as given. In the case of German banking, private commercial
banks would form the first group, and the second would consist of savings and coop-
erative banks. When private commercial banks call for changes in the industry, they
often have in mind a consolidation by buying banks from the second or third pillar.
e truly limiting factor here is not the regional principle per se, but the special legal
status of a German savings bank or cooperative bank. ere is an ongoing discussion in
Germany whether mergers across pillars, which are rare exceptions at this point, should
be facilitated. Such mergers of partners from different pillars could indirectly undermine
regional demarcation, if the new entity created were a private commercial bank (Müller
(2005, 336f.)), for the issue of privatization of savings banks). What is more, regional
demarcation restricts savings and cooperative banks in their choice of partners in merger
projects and thereby prevents them from creating the highest efficiency gain possible
(see Lang and Welzel (1999), for evidence of efficiency gains forgone in mergers among
cooperative banks). Since as of today regional demarcation is a fact of German banking
that is neither disappearing because of mergers nor becoming the most fundamental
barrier to mergers across the pillars of the banking system, and since the European
Commission in its communication explicitly referred to cooperation among savings or
cooperative banks, we focus on regional demarcation and hence do not consider mergers
in our analysis.

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