Airlines and banks over the business cycle

November 28, 2011

One of the central areas where macro and microeconomics intersect is price behavior over the business cycle, especially in industries with market power. Are prices pro-cyclical (higher during booms) or counter-cyclical? The empirical evidence varies from industry to industry. Cement prices, for example, seem to be counter-cyclical. But many industries (most?) show cyclical prices. One story for this pattern is that collusion (tacit or explicit) breaks down during downturns because “weaker” players break away from the “agreement.” For example, most airfare price wars are started by airlines in financial distress, that is, desperate for quick cash.

Recent research by our Stern finance colleague Viral Acharya (together with Nada Mora of the Kansas City Fed) shows that, during the 2007-09 crisis, banks facing a funding squeeze (or exposed to liquidity demand shocks, or with weak balance-sheets) sought to attract deposits by offering higher rates. This is similar to what we observe in industries like airlines (where we think of a high interest rate as similar to a low airfare). An additional parallel is that more aggressive pricing by “weak” players seems to drag along “stronger” players, resulting in an industry wide “price war.”

Posted by Luis Cabral


One Response to “Airlines and banks over the business cycle”

  1. An interesting point of distinction between non-financials and commercial banks is that the latter enjoy deposit insurance up to some limit. While deposit interest rates are technically not insured by the FDIC in the United States (only principal amount of deposits is), in practice FDIC is often forced to effectively insure the interest too in order to ensure no bank run takes place before they take over the bank and attempt to sell it. Now, if FDIC does not alter deposit insurance premiums for the distressed banks in a timely manner, then such distressed banks can offer excessively high interest rates to attract deposits. Given the insurance – explicit or implicit – depositors would only be more than happy to provide them with deposits (again up to the FDIC limit on size of insured deposits) rather than switch to safer banks. While distressed non-financials may also engage in price-wars, their ability to do so is at least partly limited by the market increase in their cost of funding from taking on excessively risky strategies. In contrast, distressed commercial banks may not face such discipline from creditors as they are subsidized by the taxpayers. In turn, the distressed banks may impose even greater externality on safer banks, and equally importantly, continue to remain distressed rather than bite the bullet and shed risky assets or raise more equity capital, actions that a more disciplining creditor environment (e.g., absent FDIC or with better charging of deposit insurance premiums by FDIC) would force them to undertake.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s

%d bloggers like this: