Methodology -

By Ralph Weaver,2014-11-07 04:36
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Methodology -

    What Drives Bank Competition?

    Some International Evidence

    Stijn Claessens and Luc Laeven*

    August 2003

    Abstract: Using bank-level data, we apply the Panzar and Rosse (1987) methodology to estimate the extent to which changes in input prices are reflected in revenues earned by specific banks in 50 countries‟ banking systems. We then relate this competitiveness measure to indicators of countries‟ banking system structures and regulatory regimes. We find systems with greater foreign bank entry and fewer entry and activity restrictions to be more competitive. We find no evidence that our competitiveness measure negatively relates to banking system concentration. Our findings confirm that contestability determines effective competition especially by allowing (foreign) bank entry and reducing activity restrictions on banks.

Keywords: Banking, competition, contestability, Panzar and Rosse.

JEL classification codes: D4, G21, L11, L80, O16

    * Claessens is a Professor of International Financial Policy at the University of Amsterdam and a Research Fellow at the CEPR. Laeven is an economist at the World Bank. We thank Allen Berger, Nicola Cetorelli, Hans Degryse, Enrica Detragiache, Gaston Gelos, Joseph Haubrich, Hannah Hempel, Patrick Honohan, Ross Levine, Sherrill Shaffer, Bernard Yeung, conference participants at the World Bank and at the Federal Reserve Bank of Cleveland, the editor and the referee for helpful comments. We are grateful to the World Bank and at the Federal Reserve Bank of Cleveland for support. This paper‟s findings, interpretations and conclusions are entirely those of the authors and do not necessarily represent the views of the World Bank, its Executive Directors or the countries they represent.


    Competition in the financial sector matters for a number of reasons. As in other industries, the degree of competition in the financial sector can matter for the efficiency of the production of financial services, the quality of financial products and the degree of innovation in the sector. Specific to the financial sector is the link between competition and stability, long recognized in theoretical and empirical research and, most importantly, in the actual conduct of prudential policy towards banks (Vives 2001). It has also been shown, theoretically as well empirically, that the degree of competition in the financial sector can matter for the access of firms and households to financial services and external financing, in turn affecting overall economic growth, although not all relationships are clear.

    While some relationships between competition and banking system performance and stability have been analyzed in the theoretical literature, empirical research on the issue of competition, particularly cross-country research, is still in an early stage. Data problems were previously a hindrance for the cross-country research since little bank-level data were available outside of the main developed countries; however, recently established databases allow for better empirical work. Another hindrance to the interpretation of existing empirical work has been that a number of theoretical issues are not taken into account. The long-existing theory of industrial organization has shown that the competitiveness of an industry cannot be measured by market structure indicators alone, such as number of institutions, or Herfindahl and other concentration indexes (Baumol, Panzar, and Willig 1982). The threat of entry can be a more important determinant of the behavior of market participants (Besanko and Thakor 1992). Theory also suggests that performance measures, such as the size of the banking margins or profitability, do not necessarily indicate the competitiveness of a banking system. These measures are influenced


by a number of factors, such as a country‟s macro-performance and stability, the form and

    degree of taxation of financial intermediation, the quality of country‟s information and judicial systems and bank specific factors, such as scale of operations and risk preferences. As such, these measures can be poor indicators of the degree of competition.

    Rather, testing for the degree of effective competition requires a structural, contestability approach, along the lines pursued in much of the industrial organization literature. As in other sectors, the degree of competition in the banking system should be measured with respect to the actual behavior of (marginal) bank conduct. The actual behavior should be related not only to banking market structure, but also to entry barriers, including on foreign ownership, and the severity of activity restrictions since those can limit the degree of intra-industry competition. Furthermore, the degree of competition from other forms of financial intermediation (capital markets, non-bank financial institutions, insurance companies) will play a role in determining banking system competitiveness. To date, however, few cross-country tests have taken this approach.

    These considerations suggest some advantages of using a more structural approach to assessing the degree of competition in the financial sector. While one cannot expect to address all issues, a more formal test of the degree of competition will allow one to overcome some of these concerns. It will also allow a comparison of results to other approaches of measuring competition, such as using concentration ratios, the number of banks in a market or outcomes such as banking margins. Structural competition tests have been applied to banking systems in a number of individual countries but not on a broad cross-country basis. The purpose of this paper is to estimate and document a measure of competition for a large cross-section of countries and to find factors that help to explain differences. We specifically seek to analyze the role of entry


    and activity regulations and the role of foreign banks in affecting the competitive conditions of banking systems. Additionally, we study the role of non-bank financial institutions in affecting the overall competition in the financial sector since this has received limited attention.

    Using bank-level data and applying an adapted version of the Panzar and Rosse (1987) methodology, we estimate the degree of competition in 50 countries‟ banking systems. We then relate our competitiveness measure to countries‟ structural and regulatory indicators. We find

    that systems with greater foreign bank entry and lack of entry and activity restrictions have a higher competitiveness score. We find no evidence that banking system concentration negatively relates to competitiveness. Our findings confirm that contestability helps to determine effective competition, especially through allowing (foreign) bank entry and eliminating activity restrictions.

    The paper is organized in the following manner. Section 1 provides a review of related literature both on the effects of competition in the financial sector as well as on measuring competition in general and in the financial sector specifically. Section 2 discusses the methodology used to test for the degree of competition in the banking market of a particular country. Section 3 presents the data, the selection criteria and the competitiveness measures that were used for the final sample. Section 4 relates the measure of competition to some structural and policy variables and presents the main empirical results. This section also reports several robustness tests. Section 5 concludes.


    There are several related strands of literature. Some findings of the growing literature on the definition and effects of competition in the financial sector are highlighted. The empirical


    literature that has investigated the relationships between structural and regulatory factors and performance, access to financing and growth, all as they relate to the competitive structure of the banking systems are also reviewed. Since these papers mostly do not attempt to test a specific structural model, the general theory on measuring competition is briefly reviewed as are some of the empirical papers that have applied structural competition tests to the financial sector.

A. General Effects of Competition in Banking

    As a first-order effect, one would expect increased competition in the financial sector to lead to lower costs and enhanced efficiency, even allowing for the fact that financial products are heterogeneous. Recent research has illustrated, however, that the relationships between competition and banking system performance, access to financing, stability and growth are more complex. (For a recent review of the theoretical literature on competition and banking, see Vives 2001). Market power in banking, for example, may be to a degree beneficial for access to financing (Petersen and Rajan 1995). The view that competition is unambiguously good in banking is more naive than in other industries and vigorous rivalry may not be the first best for financial sector performance. This literature has also shown that technological progress lowering production or distribution costs for financial services providers does not necessarily lead to more or better access to finance.

B. General Empirical Studies on Banking System Performance and Structure

    A number of papers have investigated the competitive condition in banking systems. In one of the first papers, Berger and Hannan (1989) investigate the commonly observed relationship between market concentration and profitability using data for U.S. banks from 1983-85. They try to separate the effects of non-competitive price behavior from that of greater efficiency for


    firms with larger market shares and find that non-competitive price behavior could explain the relationship. Other studies have focused on the effects of consolidation in the banking systems. (For a review of some earlier studies on consolidation and its effect on bank lending terms, see Gilbert 1984. For a review of more recent studies on the effects of consolidation, including studies on the effects of consolidation on access to financing, see Berger, Demsetz, and Strahan 1999.) While many of these papers are not formal structure-performance-conduct tests, their results have been interpreted as being indicative of the degree of competition and/or its causes and consequences in the financial sector (Berger 1995).

    A number of recent papers have investigated the effects of regulations and specific structural or other factors presumed to relate to the competitive environment on banking performance. In a broad survey of rules governing banking systems, Barth, Caprio and Levine (2001) document, for 107 countries, various regulatory restrictions that were in place in 1999 on commercial banks, including various entry and exit restrictions and practices. Using this data, Barth, Caprio and Levine (2003) document, among others, that tighter entry requirements are negatively linked with bank efficiency, leading to higher interest rate margins and overhead expenditures, while restricting foreign bank participation tends to increase bank fragility. These results are consistent with the view that tighter entry restrictions tend to limit competition and emphasize that it is not the actual level of foreign presence or bank concentration, but the contestability of a market that determines bank efficiency and stability.

    In a cross-country study on banking structure, Claessens, Demirgüç-Kunt and Huizinga (2001) investigate the role of foreign banks and show that entry by foreign banks makes domestic banking systems more efficient by reducing margins. Using bank-level data for 77 countries, Demirgüç-Kunt, Laeven, and Levine (2003) investigate the impact of bank


    concentration and regulations on bank efficiency. They find that bank concentration has a negative and significant effect on the efficiency of the banking system except in rich countries with well-developed financial systems and more economic freedoms. Furthermore, they find bank-level-based support that regulatory restrictions on entry of the new banks, particularly concerning foreign banks, and implicit and explicit restrictions on bank activities, are associated with lower levels of bank margins. Their measure of bank efficiency, net interest margin, is not necessarily an indicator of the actual degree of competitive conduct in a market, but may reflect other factors, such as market power and risk preferences. They mitigate this problem by controlling for a number of differences across banks and countries such that they can interpret higher net interest margins as reflecting operational inefficiency. Our paper adds to this literature by using an indicator that directly measures the actual degree of competitive conduct.

C. Competition Testing: Theory

    Most papers reviewed thus far did not test for the degree of competition in the banking system using a specific structural model. The theory of contestable markets has, however, drawn attention to the fact that there are several sets of conditions that can yield competitive outcomes, with competitive outcome possible even in concentrated systems. On the other hand, collusive actions can be sustained even in the presence of many firms.

    The concept of contestability has spanned a large theoretical and empirical literature covering many industries. Two types of empirical tests for competition have been applied to the financial sector (and other industries). The model of Bresnahan (1982) and Lau (1982), as expanded in Bresnahan (1989), uses the condition of general market equilibrium. The basic idea is that profit-maximizing firms in equilibrium will choose prices and quantities such that marginal costs


    equal their (perceived) marginal revenue, which coincides with the demand price under perfect competition or with the industry‟s marginal revenue under perfect collusion. This model allows for an easy-to-use test statistic and a direct relationship to a natural measure of excess capacity. Specifically, a parameter can be estimated which provides a measure of the degree of imperfect competition, varying between perfect competition and full market power. One empirical advantage is that one only needs to use industry aggregate data to estimate this parameter, although using firm-specific data is also possible.

    The alternative approach is Rosse and Panzar (1977), expanded by Panzar and Rosse (1982) and Panzar and Rosse (1987). This methodology, abbreviated here to the PR model, uses firm (or bank)-level data. It investigates the extent to which a change in factor input prices is reflected in (equilibrium) revenues earned by a specific bank. Under perfect competition, an increase in input prices raises both marginal costs and total revenues by the same amount as the rise in costs. Under a monopoly, an increase in input prices will increase marginal costs, reduce equilibrium output and consequently reduce total revenues. The PR model also provides a measure (“H-statistic”) between 0 and 1 of the degree of competitiveness of the industry, with

    less than 0 being a collusive (joint monopoly) competition, less than 1 being monopolistic competition and 1 being perfect competition. It can be shown, if the bank faces a demand with constant elasticity and a Cobb-Douglas technology, that the magnitude of H can be interpreted as an inverse measure of the degree of monopoly power, or alternatively, as we do, as a measure of the degree of competition.

    The advantage of the PR model is that it uses bank-level data and allows for bank-specific differences in production function. It also allows one to study differences between types of banks (e.g., larges versus small, foreign versus domestic). Its drawback is that it assumes that


    the banking industry is in long-run equilibrium, however, a separate test exists to determine

    1 As we have access to bank-level information and as we want whether this condition is satisfied.

    to study differences among banks, we choose for the PR model. (The empirical specification we use is explained in section two.)

D. Competition Testing: Empirical Results for Banking Systems

    A number of papers have applied either the Bresnahan or the PR methodology to the issue of competition in the financial sector, although mostly to the banking system specifically. Cetorelli (1999) provides more detail on these formal tests and reviews results of previous studies of empirical banking studies. One of the first applications of the Bresnahan test is Shaffer (1989). For a sample of US banks, he finds results that strongly reject collusive conduct but are consistent with perfect competition. Using the same model, Shaffer (1993) finds that the Canadian banking system was competitive over the period 1965-1989 despite being relatively concentrated. Gruben and McComb (2003) find that the Mexican banking system before 1995 was super-competitive, that is, marginal prices were set below marginal costs. Shaffer (2001) uses the Bresnahan model for 15 countries in North America, Europe, and Asia during 1979-91. He finds significant market power in five markets and excess capacity in one market. Estimates were consistent with either contestability or Cournot type oligopoly in most of these countries, while five countries were significantly more competitive than Cournot behavior would imply.

    Shaffer (1982) applied the PR model to a sample of New York banks using data for 1979 and found monopolistic competition. Nathan and Neave (1989) studied Canadian banks using the PR methodology and found results consistent with the results of Shaffer (1989) using the Bresnahan

     1 In case of short-run, but not long-run equilibrium, the parameter H represents a one-tail test in the sense that a positive value rejects any form of imperfect competition but a negative value is consistent with a variety of


    methodology, i.e., a rejection of monopoly power. Several papers have applied the PR

    2 Generally, the papers reject both perfect collusion methodology to European banking systems.

    as well as perfect competition and find mostly evidence of monopolistic competition. (Bikker and Haaf 2001 summarize the results of some ten studies.) Some studies have applied the PR methodology to some non-North American and non-European banking systems. For Japan, Molyneux, Thornton and Lloyd-Williams (1996) find evidence of a monopoly situation in 1986-1988. Tests on the competitiveness of banking systems for developing countries and transition economies using these models are few to date. (Gelos and Roldos 2002, for example, using the PR-methodology, report that banking markets of eight European and Latin American countries have not become less competitive, although concentration has increased.)

    Some studies find differences between types of banks. For example, De Bandt and Davis (2000) find monopoly behavior for small banks in France and Germany while they find monopolistic competition for small banks in Italy and for the large banks in all three countries in their sample. This suggests that in these countries small banks have more market power perhaps as they cater more to local markets.


    We use the Panzar and Rosse (1982, 1987) (henceforth PR) approach to assess the competitive nature of banking markets around the world. The PR H statistics is calculated from reduced form

    bank revenue equations and measures the sum of the elasticities of the total revenue of the banks with respect to the bank‟s input prices. The PR H statistic is interpreted as follows. H<0 indicates

possibilities, including short-run competition (Shaffer 1983).


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