The deregulation of interest rates in the early 1980s raised bank funding costs and lowered profits. In response, banks raised fees for deposit services, reduced branch operating costs, and shifted to higher earning assets. Rates of return did not regain their prederegulation levels until the early 1990s. Our goal is to decompose the change in bank profits following deregulation into (i) internal, bank-initiated adjustments to the new regulatory structure and (ii) external, contemporaneous changes in banks' business environment. This decomposition will depend, in part, on the assumed competitive structure of the banking industry. With perfect competition, output and input prices are part of the external environment and banks' responses are limited to changes in output and input quantities. An alternative approach assumes imperfect competition where banks have some control over output prices (deposit fees, minimum balance requirements, and interest rates on certain loans) and output quantities and input prices comprise the external environment. The alternative model is supported by the data. Using this model, large banks-but not smaller banks-are found to have relied primarily on changing output prices and input use to mitigate and reverse the negative effects of deregulation on profits. The adjustment to deregulation was essentially complete after four years. Following this, additional changes in bank profitability (during the late 1980s) were primarily due to changes in banks' business environment.
