1. CONSUMER SWITCHING COSTS AND FIRM PRICING: EVIDENCE FROM BANK PRICING OF DEPOSIT ACCOUNTS By Timothy H. Hannan

2. This paper employs extensive information on bank deposit rates and county migration patterns to test for pricing relationships implied by the existence of switching costs.

3. It relies on the following propositions: 1.Banking markets are local. 2. Existing customers incur switching cost to open accounts at new banks, but in-migrants do not face switching costs relevant to their choice of bank. 3. Banks view the time that an in-migrant can be expected to stay in the area as relevant to the pricing decisions that they make to attract new customers.

4. Preview of Results 1.Because some areas experience more in- migration than others, banks, in addressing the tradeoff between attracting new customers and exploiting old ones, offer higher deposit rates in areas (and at times) characterized by greater in- migration.

5. Preview of Results 2.Because out-migration implies that on average a locked-in customer will not be with the bank as many periods, greater out-migration changes the bank’s assessment of this trade-off such that the bank offers lower deposit rates in areas (and during periods) that experience greater out-migration.

6. Preview of Results 3.Because this effect of out-migration logically depends on the existence and extent of in-migration, an interaction is implied. Consistent with this, out-migration has more of an effect on pricing, the greater is in-migration. 4.Consistent with increasing switching costs over time, account types that should be subject to greater switching costs exhibit the biggest reduction in deposit rates

7. Literature: Theory One-period Two period Multi-period, where new customers are entering the market, old customers are leaving the market, and the firm cannot distinguish between old “locked-in” customers and new customers in its pricing. Beggs and Klemperer (1992).

8. Literature: Empirical Sharpe (1997) Hannan, Kiser, Prager, and McAndrews (2003)

9. denotes discounted future profits at time t. denotes the rate earned on securities at time t. denotes bank i’s deposit rate at time t new t denotes the number of new customers entering the market at t. denotes the share of new customers attracted to bank i. denotes a discount factor denotes the number of bank I’s locked-in customers at t denotes the proportion of market depositors that “survive” to t+1 Theoretical Model (1)

10. Theoretical Model As an empirical matter, I measure the “survival rate” as: Differentiation of (1) with respect to the bank i‘ s deposit rate, division by pop t, and making this substitution yields:

11. Theoretical Model --The higher the rate of market in-migration the higher the deposit rate. --The higher the rate of market out-migration, the lower the deposit rate, but only in interaction with the rate of in-migration. --The greater the discount factor and security rate, the greater the deposit rate. --Size, as expressed by x i ?

12. Empirical Model It follows that:

13. Data 12,000 observations of banks observed annually from 1989 to 2004. For each bank and year, interest rates were calculated from balance sheet and income data for four different kinds of deposit account : interest-bearing transaction accounts (itrate), savings deposits (svrate), small time deposits (smtrate), and large time deposits (lgtrate).

14. Data Migration data constructed from year-to-year changes in addresses, available on a county basis, derived from the population of returns from the IRS Master File. In-migrants—address outside the county at time t-1 and inside the county at t. Out-migrants—address in the county at time t- 1 and address outside the county at t.

15. Data Following previous studies, markets are defined as metropolitan areas (in the case of urban markets) or BLS labor market area (in the case of rural markets). All are coterminous with counties.

20. Conclusion Consistent with the importance of switching costs: 1.Deposit rates are higher in markets with greater in-migration 2.Deposit rates a lower in markets with greater out-migration 3.The effects of in-migration and out- migration interact such that out-migration has a bigger effect, the greater is in- migration (and in-migration has a smaller effect, the greater in out-migration)

21. Conclusion 4. Consistent with increasing switching costs over time, the deposit rate of the account type that should be most subject to switching costs (interest bearing transaction accounts) tended to decline by more than the rates offered on other account (Speculative). --