The Impact of Market Structure, Contestability and Institutional Environment on Banking Competition

1
The Impact of Market Structure, Contestability
andInstitutional Environment on Banking
Competition

• Jacob Bikker (DNB, UU), Laura Spierdijk (RUG)
• and Paul Finnie (UBS)
• Eurobanking 2008
• 18-21 May 2008
• Maribor, Slovenia

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Competition

• Banking competition is very important.
• Competition
• Raises social welfare (lowers prices and improves
  quality)
• Fosters innovative behavior
• Strengthens monetary policy
• Has impact on Solvency and Financial stability
• Promotes access of households and firms to
  financial services, thereby enhancing economic
  growth

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Aim of our paper

• For competition policy we need to know what
  determinants explain the degree of competition?
• So aim of our paper is What drives competition?
• Step 1 Measure competition (gt H)
• Step 2 Explain competition (select determinants
  gt X)

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Step 1 Measure competition PR model
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Step 1 Measure competition PR model
Input factor prices 1. Funding rate 2. Wage
rate3. Price of investment other
expenses Other variables4. Loan share (risk) 5.
Equity ratio (leverage/risk) 6. Other income
(product mix) 7. Share of deposits (funding
mix) 8. Share of non earning assets (composition
of assets)
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Discriminatory power of H
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Discriminatory power of H
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Step 1 Measure competition PR model
We have selected data of 17.500 banks in 89
countries over 10 years (1995-2004), together
100.000 observations This gives PR estimates of
H for 89 countries Where H changes over time
(33 of the countries), we take the value for
2004
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Step 2 Explain competition

• Potential variables concern
• Market structure
• Contestability factors
• Inter-industry characteristics
• Institutional features
• Macro-economic situation

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Variables explaining competition (1)

• Market structure variables
• Banking concentration ratios (CR5, HHI)
  CR5
• Number of banks
• Foreign ownership of banks ()
• Contestability variables
• (Cross-sector) activity restrictions
  (2)

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Variables explaining competition (2)

• Inter-industry variables
• Log (Life insurance / GDP)
  ()
• Market capitalization / GDP
  (3)
• Institutional variables
• Property rights index
• Banking freedom index
• Regulation index
  (4)
• Restrictions on foreign investments
  (5)
• Socialist History
  (6)
• EU15 (7)

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Variables explaining competition (3)

• Macro-economic conditions
• Log (GDP / Capita) or development
  (8)
• Log (Inflation)
• Real growth of GDP or business cycle
  (9)
• 
  (WLS)

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Data

• We have only country-specific data on explanatory
  variables for 76 out of 89 countries if we delete
  two explanatory variables
• Alternatively, for each extra explanatory
  variables, we lose 10 countries
• Data refer to 2004

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Estimation results (2004)
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Results

• A remarkable result is that banking market
  concentration has no negative impact on
  competition, as the traditional literature
  suggest (assuming a static relationship). A more
  modern and dynamic interpretation of this
  variable is that competition may force banks to
  consolidate, so that competitive banks end up in
  a concentrated market.
• This results is recently also found in other
  studies

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Interpretation of the results

• Banks exert more market power in countries with
  higher GDP per capita, that is, during peaking
  business cycles (explanation less fighting for
  market shares if the market increases)
• Banks have more market power in countries to
  which foreign investors have less access (in line
  with expectations)
• Banks become more competitive when regulation is
  stricter (explanation part of regulation deals
  with ban on competitive restrictions)
• Former Socialist countries have not yet fully
  developed competitive behaviour

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Relative importance of variables

• The factors that contribute most in explaining
  competition (based on squared partial
  correlation)
• Socialist legal history
• Foreign investment index
• Growth GDP
• Regulation index

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Robustness tests

• Replacing HHI and Number of banks for CR5
• Add two more explanatory variables foreign
  ownership and life insurance sector size
  (lowering the sample size)
• OLS instead of WLS
• 2SLS (as market structure variables might be
  endogenous)
• Higher minimum number of banks per country
• gt All results were unaffected

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Comparison to existing literature

• Claessens Laeven (2004) find that the
  significant determinants of bank competition
  during 1994-2001 are
• foreign ownership () and activity restrictions
  (-)
• However
• they take only 22-39 countries into account
  (depending on variant)
• they use a limited set of explanatory variables
  only
• our approach is more robust (deleting correlated
  variables)
• they use explanatory variables originating from
  various years

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Step 3 Large banks versus small banks (1)

• We have found in an earlier paper that small and
  large banks have different competitive behavior
• Large banks operate on other product markets
  (with relatively less competition) or employ more
  market power (due to e.g. brand name) and may be
  in a better position to collude
• Therefore, we explicitly distinguish between
  small and large banks

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Step 3 Large banks versus small banks (2)

• We estimate PR with the quantile regression
  approach and obtain H(t), that is, a function of
  H depending on size (t in (0,1))
• We take t 0.1 (small banks) and t 0.9 (large
  banks).

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Step 3 Large banks versus small banks (3)

• We find quite similar results as before
• The most important change is that large banks
  depend also on activity restriction in the
  sense that more cross-sector restrictions
  increase their market power (similar to Claessens
  Laeven (2004))
• Remarkably, both small and large banks are less
  competitive in the EU15. We attribute this to
  relatively more developed sophisticated banking
  products

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Conclusions

• Obvious policy advice, particularly for less
  developed markets
• more regulation reducing competitive obstacles
• no obstacles for foreign investment
• reduce cross-sector restrictions
• Developments of new, sophisticated products may
  reduce competition, due to their opaque nature.
  This may require more regulation