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Bank Competition: What is the Role of the Government?

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1 Bank Competition: What is the Role of the Government?
César Calderón (FPDCE), Maria Soledad Martínez Pería (DECFP), Mauricio Pinzón Latorre (FPDCE), Klaus Schaeck (Bangor University)

2 Roadmap Motivation Key messages
Measurement and trends in banking competition Banking competition and financial development Drivers of banking competition Additional background work for the Chapter Conclusions and policy implications

3 2. Key messages Greater bank competition can:
Raise bank efficiency Enhance access to financial services Promote bank stability Quality of regulatory framework is key to guarantee: Greater market contestability Positive side effects from enhanced competition Government may play a role in enhancing competition by designing policies that: Build a strong institutional framework Guarantee market contestability Design of entry/exit policies, prudential regulation and supervision should shape incentive framework that minimizes excessive risk-taking in the face of greater competition.

4 3. Measurement and trends in bank competition
Goal: Assemble a comprehensive array of indicators of banking competition. Data source: Bankscope Three types of indicators Structural measures (SCP paradigm): Market structure Share of assets held by the k largest banks (k=3, 5) Herfindahl-Hirschman index (assets- and loan-based) Contestability measures: ease of entry and exit Requirements for bank licenses Share of licenses denied Non-structural measures (New empirical IO): Market power H-Statistic Lerner Index

5 3. Measurement and trends in bank competition
H-Statistic (Panzar & Rosse, 1982, 1987) Elasticity of bank interest revenues to input prices Greater values of H implies more intensive banking competition (under certain conditions) Valid only if market in long-run equilibrium Lerner Index (Lerner, 1934) Divergence between prices and marginal costs Not a long run equilibrium measure We can build a time series Limitations of measures of competition Structural features of markets irrelevant as long as markets are contestable Measures used are country-level, but competition may vary by product and by markets, where markets may be defined at the state or country level

6 3. Trends in competition: Market concentration
Asset share of 5 largest banks (CR5) Industrial and Developing Countries Source: GFDR Team’s calculation based on data from Bankscope. Median values across country groups are reported.

7 3. Trends in competition: Market concentration
Asset share of 5 largest banks (CR5) Across Developing Regions, (Average) Source: GFDR Team’s calculation based on data from Bankscope. Median values across country groups are reported.

8 3. Trends in Competition: Contestability
Barriers to Entry Industrial vs. Developing Countries Share of denied licenses Industrial vs. Developing Countries Barriers to entry (Index of entry into banking requirements). It comprises the different types of legal submissions required to obtain a banking license –that is information on whether the following requirements have to be submitted before issuance of a banking license: (a) Draft by-laws, (b) Intended organization chart, (c) Financial projections for first three years, (d) Financial information on main potential shareholders, (e) Background/experience of future directors, (f) Background/experience of future managers, (g) Sources of funds to be disbursed in the capitalization of new bank, and (h) Market differentiation intended for the new bank. Share of denied licenses. The fraction of entry applications (domestic and foreign) that has been denied. Note: The index of entry into banking requirements captures whether various types of legal submissions are required to obtain a banking license. Higher scores indicate higher restrictions on entry into banking. On the other hand, the share of denied licenses is the ratio of denied to total banking licensing requests. Source: Bank regulation and supervision survey (Barth, Caprio and Levine, 2001, 2004, 2006, 2012). Elaboration: GFDR Team.

9 3. Trends in Competition: Contestability
Barriers to Entry By Developing Regions Share of denied licenses By Developing Regions Note: The index of entry into banking requirements captures whether various types of legal submissions are required to obtain a banking license. Higher scores indicate higher restrictions on entry into banking. On the other hand, the share of denied licenses is the ratio of denied to total banking licensing requests. Source: Bank regulation and supervision survey (Barth, Caprio and Levine, 2001, 2004, 2006, 2012). Elaboration: GFDR Team.

10 3. Trends in Competition: H-Statistic
H-Statistic: Industrial and Developing Countries The Panzar and Rosse (1982, 1987) H-statistic captures the elasticity of bank interest revenues to input prices. The H-statistic is calculated by estimating the equation below Ln(Pit)= αi + β1 ln(W1,it) + β2 ln(W2,it) + β3 ln(W3,it) + γ ln(Z,it) + δD + εit where i denotes banks and t denotes years. P is the ratio of gross interest revenues to total assets (proxy for the output price of loans), W1 is the ratio of interest expenses to total deposits and money market funding (proxy for input price of deposits), W2 is the ratio of personnel expenses to total assets (proxy for input price of labor) and W3 is the ratio of other operating and administrative expenses to total assets (proxy for input price of equipment/fixed capital). Z is matrix of controls Finally, αi denote bank-level fixed effects. The H-statistic equals β1 + β2 + β3. To verify the condition of long-run equilibrium, the following regression is estimated: Ln(ROAit)= αi + β1 ln(W1,it) + β2 ln(W2,it) + β3 ln(W3,it) + γ ln(Z,it) + δD + εit where ROA is the pre-tax return on assets. Because ROA can take on negative values, we compute the dependent variable as ln(1+ROA). We define the equilibrium E-statistic as β1 + β2 + β3 from equation (2). The test of long-run equilibrium involves testing whether E=0. Note: H-Statistic figures are calculated for commercial banks based on data from Bankscope and following the methodology described in Demirguc-Kunt and Martínez-Pería (2010). Elaboration: GFDR Team.

11 3. Trends in Competition: H-Statistic
H-Statistic Across Developing Regions, Note: H-Statistic figures are calculated for commercial banks based on data from Bankscope and following the methodology described in Demirguc-Kunt and Martínez-Pería (2010). Elaboration: GFDR Team.

12 3. Trends in Competition: Lerner Index
Banking Competition Lerner Index across the World Source: GFDR Team’s calculation based on data from Bankscope following the methodology described in Demirguc-Kunt and Martínez Pería (2010).

13 3. Trends in Competition: Lerner Index
Annual Evolution: Industrial vs. Developing Countries Period averages: Industrial vs. Developing Countries A frequently used measure of market power in banking is the Lerner index, defined as the difference between output prices and marginal costs (relative to prices). The advantage of the Lerner Index, vis-à-vis the H-statistic, is that it is not a long-run equilibrium measure of competition. Also, because of this, the Lerner index can be calculated at each point in time. The Lerner Index is computed using the formula (P-MC)/P, where P is the price of banking outputs and MC is the marginal costs. P is calculated as total bank revenue over assets and MC is calculated by taking the derivative from a translog cost function as specified in the equation below: Ln(Cit) = a0i + b0ln(Qit) + b10.5[ln(Qit)]2 + a1ln(W1it )+ a2ln(W2it) + a3ln(W3it)+ b20.5ln(Qit)*ln(W1it) + b30.5ln(Qit)*ln(W2it) + b40.5ln(Qit)*ln(W3it) + a4ln(W1it)*ln(W2it) + a5ln(W1it)*ln(W3it) + a6ln(W2it)*ln(W3it) + a70.5[ln(W1it)]2+ a80.5[ln(W2it)]2 + a90.5[ln(W3it)]2 + d1Trend + d2Trend2 + d3Trend*ln(Qit)+d4Trend*ln(W1it ) + d5Trend*ln(W2it ) + d6Trend*ln(W3it ) + uit where i denotes banks and t denotes years. C is total operating plus financial costs, Q is total assets, W1 is the ratio of interest expenses to total deposits and money market funding (proxy for input price of deposits), W2 is the ratio of personnel expenses to total assets (proxy for input price of labor) and W3 is the ratio of other operating and administrative expenses to total assets (proxy for input price of equipment/fixed capital). Source: GFDR Team’s calculation based on data from Bankscope following the methodology described in Demirguc-Kunt and Martínez Pería (2010).

14 3. Trends in Competition: Lerner Index
Lerner Index Across Developing Regions Source: GFDR Team’s calculation based on data from Bankscope following the methodology described in Demirguc-Kunt and Martínez Pería (2010).

15 3. Trends in Competition: Concentration vs. Competition
H-Statistic vs. CR5 Lerner Index vs. CR5 Source: GFDR Team’s calculation based on data from Bankscope following the methodology described in Demirguc-Kunt and Martínez Pería (2010).

16 4. Banking competition and financial development
Bank competition can impact various dimensions of financial development such as efficiency, access, and stability. Efficiency Alternative theories on the competition-efficiency nexus Quiet Life (Hicks, 1935) – without competition banks relax their efforts to control costs. Efficient Structure (Demsetz, 1973) – points to reverse causation between efficiency and concentration: more efficient firms are able to gain greater market shares. Studies focusing on direct measures of competition or contestability show that competition brings about efficiency improvements. Developed countries (Schaeck and Cihak, 2011; Evanoff and Ors, 2008; Demirguc-Kunt et al. , 2004) Developing countries (Lin, Ma and Song, 2010; Turk-Ariss, 2010) There are two views regarding the direction of causality between competition and efficiency. The “quiet life” hypothesis (Hicks 1935) argues that monopoly power allows banks to relax their efforts, increase their costs and, hence, predicts a positive link from competition to efficiency. On the other hand, the “efficient-structure” hypothesis proposed by Demsetz (1973) predicts a negative relationship between competition and efficiency, where causality runs from efficiency to competition. According to this view, the best-managed more efficient firms are able to secure the largest market shares, which leads to a higher level of concentration and lower levels of competition. Empirical studies focused on the link between efficiency and concentration have produced mixed results. Berger (1995) on US banks and Goldberg and Rai (1996) on European banks have found evidence consistent with the efficient-structure hypothesis, where efficient banks are able to gain market share and concentration increases as a result. On the other hand, Berger and Hannan (1998) show that banks operating in concentrated markets are more inefficient. However, most of these studies analyze the link between efficiency and market structure as opposed to direct measures of competition or contestability. This is important since many studies have concluded that concentration is not a good measure of competition (see Cetorelli, 1999, Claessens and Laeven, 2004, and Demirguc-Kunt, Laeven, and Levine, 2004 among others). In the case of the of the US, a number of papers have shown that deregulation – removing interstate branching restrictions – and the threat of bank entry have led to improvements in efficiency. For example, Jayaratne and Strahan (1998) find that following deregulation operating costs and loan losses decrease sharply. The improvements following branching deregulation appear to occur because better banks grow at the expense of their less efficient rivals. De Young, Hasan, and Kirchhoff (1998) find that after deregulation the efficiency of incumbent banks first declines and then increases over time. Evanoff and Ors (2008) analyze the cost efficiency of non-merging banks following the consolidation that resulted from deregulation. They find that incumbent banks respond by improving their cost efficiency. There is also significant evidence of a positive link between efficiency and competition in a cross-country setting. Using data for more than 14,000 banks operating in Europe and the US, Schaek and Cihak (2008) a positive effect of competition on measures of profit and cost efficiency. Using a local maximum likelihood technique to obtain joint estimates of efficiency and market power among banks in the European Monetary Union, Delis and Tsionas (2009) find evidence of a negative relationship, which is in line with the so-called ‘‘quiet life hypothesis”. Similar findings are obtained when the sample of countries is extended to include developing countries. Using data on net interest margins and overhead costs for over 1,400 banks in 72 developed and developing countries, Demirguc-Kunt, Laeven and Levine (2004) find that tighter regulations on bank entry and bank activities lead to higher costs of financial intermediation. A similar result is found by Lin, Ma and Song (2010) for 2,500 banks operating in 74 countries. Finally, focusing on 60 developing countries, Turk-Assis (2010) also finds a significant negative association between bank market power (as measured by the Lener index) and cost efficiency. Overall, the recent empirical literature that assesses the impact of direct measures of competition on efficiency finds that competition brings about improvements in efficiency in both developed and developing countries. One exception is Casu and Girardone (2009) who find a positive causation between market power and efficiency for 2701 banks operating in France, Germany, Italy, Spain and Uk over The authors also find that concentration is positively associated with net interest margins, however, this relationship breaks down when controlling for regulatory impediments to competition and inflation.

17 4. Banking competition and financial development
Access Ambiguous theoretical prediction for competition-access link Market power hypothesis argues that competition in the banking market reduces the cost of finance and increases the availability of credit. Information hypothesis argues that, in the presence of information asymmetries and agency costs, competition can reduce access by making it more difficult for banks to internalize the benefits of investing in building lending relationships, in particular, with opaque clients (Petersen and Rajan, 1995; Marquez, 2002). Evidence between concentration and access yields mixed result. But, studies using direct measures of competition find that competition improves access (see Claessens and Laeven, 2005; Carbó et al. 2009). Theory provides ambiguous predictions regarding the effect of competition on access to finance. The conventional market power hypothesis argues that competition in the banking market reduces the cost of finance and increases the availability of credit. On the other hand, the information hypothesis argues that, in the presence of information asymmetries and agency costs, competition can reduce access by making it more difficult for banks to internalize the benefits of investing in building lending relationships, in particular, with opaque clients (Petersen and Rajan, 1995; Marquez, 2002). Most of the existing empirical studies on this question have used concentration as a measure of competition and yield mixed results. Using data from the US, Petersen and Rajan (1995) find that SMEs are more likely to obtain financing when credit markets are concentrated and Zarutskie (2006) finds that deregulation in the US, which increased the competitiveness of US banking markets, caused newly formed firms to use significantly less external debt, consistent with the notion that competition exacerbates credit constrains. Using survey dataset of German manufacturing firms, Fischer (2000) finds that more concentration leads to more information acquisition and greater credit availability. On the other hand, using enterprise survey data for 74 countries, Beck, Demirguc-Kunt, and Maksimovic (2004) find that in more concentrated banking markets firms of all sizes face higher financing obstacles and that the effect of concentration decreases with firm size. Chong, Lu, and Ongena (2011) also find a positive association between concentration and credit constraints using a survey on the financing of China’s SMEs combined with detailed bank branch information. On top of the mixed evidence, because concentration is not always a reliable measure of competition, it is hard to draw inferences about the link between competition and access from the studies mentioned above. However, studies that focus on direct measures of competition and contestability offer some interesting new evidence. Using data on growth in industry value added over for 16 countries, and measuring competition at the country-level using the Panzar and Rosse H-statistic, Claessens and Laeven (2005) find that competition is positively associated with countries’ industrial growth. The authors argue that this suggests that more competitive banking sectors are better at providing financing to financially dependent firms. Exploiting a very rich data on Spanish SMEs, Carbo, Rodriguez Fernandez, and Udell (2009) also find evidence that competition promotes access to finance using an alternative direct measure of competition, the Lerner index. At the same time, the authors find that their results for the Lerner index are not consistent with results using concentration as a measure of competition. They conclude that “researchers and policymakers need to be very careful in drawing strong conclusions about market power and credit availability based on analysis that rely exclusively on concentration as a measure of market power”. In sum, similarly to what we find on the link between competition and efficiency, the evidence that measures bank competition directly – as opposed to focusing on bank concentration - suggests that the latter is beneficial for the financial sector. In particular, bank competition enhances access to credit.

18 4. Banking competition and financial development
Stability Competing theories explaining competition-stability relationship Competition-fragility view predicts that competitive banking systems are less stable, because competition reduces bank profits and erodes the charter value of banks, increasing banks’ incentives for excessive risk-taking (see Marcus, 1984; Chan, Greenbaum and Thakor, 1986; and Keeley, 1990). Competition-stability view argues that since in less competitive sectors banks can charge higher interest rates, this may induce firms to assume greater risk, resulting in a higher probability that loans become non-performing. Similarly, higher interest rates might attract riskier borrowers through the adverse selection effect (Boyd and De Nicoló, 2005). There are competing theories that explain the link between competition and stability. The traditional competition-fragility view predicts that competitive banking systems are less stable, because competition reduces bank profits and erodes the charter value of banks, consequently increasing banks’ incentives for excessive risk-taking (see Marcus, 1984; Chan, Greenbaum and Thakor, 1986; and Keeley, 1990). Furthermore, in more competitive environments, banks earn lower informational rents from their relationship with borrowers, reducing their incentives to properly screen borrowers, again increasing the risk of fragility (Boot and Greenbaum, 1993; Allen and Gale, 2000, 2004). Competition can also destabilize the banking sector through its impact on the interbank market and the payments system. For example, if all banks are price-takers in a competitive market, banks have no incentives to provide liquidity to a troubled bank, leading to bank failure and creating negative repercussions for the entire sector (see Allen and Gale, 2000). A somewhat different argument in support of the competition-fragility view is that more concentrated banking systems have larger banks, which in turn allows them to diversify their portfolios better. A final argument in the competition-fragility view refers to the number of banks to be supervised by the authorities. If a more concentrated banking system implies a smaller number of banks, this might reduce the supervisory burden and thus enhance overall banking system stability. The competition-stability view argues that the notion that market power in banking boosts profits and bank stability ignores the potential impact of banks' market power on borrowers' behavior. Boyd and De Nicoló (2005) argue that since in less competitive sectors banks can charge higher interest rates, this may induce firms to assume greater risk, resulting in a higher probability that loans become non-performing. Similarly, higher interest rates might attract riskier borrowers through the adverse selection effect. Thus, in contrast to the charter-value hypothesis, Boyd, and De Nicoló (2005) predict that banks' actions will result in more risk-taking and greater fragility in more concentrated and less competitive banking systems. Advocates of the competition-stability view also disagree with the notion that concentrated banking systems characterized by few large banks are easier to monitor than less concentrated banking systems with many banks, since larger banks can be more complex and, hence, harder to supervise. The early empirical literature on the link between competition and stability is mixed. A number of country-specific studies have shown that increasing competition leads to greater individual bank risk-taking (see for example Keeley, 1990 and Dick, 2006, in the case of the US; Jimenez, Lopez and Saurina, 2007 in the case of Spain). However, at the same time, some studies have failed to find that larger banks are less likely to fail as would be predicted by the competition-fragility view (Boyd and Runkle, 1993; Boyd and Graham, 1991, 1996; De Nicoló, 2000) Recent papers using cross-country, time-series datasets offer evidence supporting the competition-stability view. Beck, Demirgüç-Kunt and Levine (2006 a,b) find that more competitive banking systems (defined as those with fewer regulatory restrictions on bank entry and activities) are less likely to suffer systemic banking distress. This finding is confirmed by Schaeck, Cihak, and Wolfe (2006), who find a negative relationship between bank competition and systemic bank fragility using the H-statistic to measure competition. Schaeck and Cihak (2007) identify bank capitalization as one of the channels through which competition fosters stability. Using data for more than 2,600 European banks, they show that banks have higher capital ratios in more competitive environments. This is consistent with Berger, Klapper and Turk-Ariss (2008), who find that banks in more competitive banking systems take greater lending risks, but compensate with a higher capital-asset ratio, resulting in an overall lower level of bank risk, as measured by the z-score. Measures of bank risk such as the z-score ignore systemic stability but regulators are concerned with systemic stability much more than with the absolute level of risk of individual banks. In a recent paper, Anginer, Demirguc-Kunt and Zhu (2011) introduce a new measure of systemic risk-taking by banks, measured as the total variation of changes in default risk of a given bank (as measured using Merton 1973 contingent claim pricing framework) explained by changes in default risk of all other banks in a given country. After controlling for various bank- and country-level variables, Anginer et al. (2011) find a positive relationship between competition and systemic stability. Overall, the advantages of competition for an efficient and inclusive financial system are significant. Furthermore, not only do recent studies suggest a positive link between competition and stability, but also policy bodies such as the OECD Competition Committee have suggested that to promote banking stability, policymakers should not use competition policy but rather should design and apply better regulations. See Beck (2008) for a thorough review of the theoretical and empirical literature on bank competition and stability. The authors also find a negative link between concentration and fragility. However, they conclude that the finding that competition reduces fragility when controlling for concentration suggests that something else besides a positive relationship between bank concentration and bank profits drives the negative link between concentration and fragility. They conclude that concentration might be an insufficient measure of bank competition. See

19 4. Banking competition and financial development
Stability. Early country specific bank-level studies yield mixed results. Three strands of recent studies provide evidence of positive link between competition and stability. Regulatory restrictions on bank entry and exit promote systemic banking distress (Beck, Demirguc-Kunt and Levine, 2006 a, b) Bank competition (H-Statistic) reduces systemic bank fragility (Schaeck, Cihak and Wolfe, 2009) Competition (Lerner index) is associated with greater systemic stability (Anginer, Demirguc-Kunt, and Zhu, 2011). OECD Competition Committee. Design and application of better regulations (rather than competition policies) to promote banking stability. There are competing theories that explain the link between competition and stability. The traditional competition-fragility view predicts that competitive banking systems are less stable, because competition reduces bank profits and erodes the charter value of banks, consequently increasing banks’ incentives for excessive risk-taking (see Marcus, 1984; Chan, Greenbaum and Thakor, 1986; and Keeley, 1990). Furthermore, in more competitive environments, banks earn lower informational rents from their relationship with borrowers, reducing their incentives to properly screen borrowers, again increasing the risk of fragility (Boot and Greenbaum, 1993; Allen and Gale, 2000, 2004). Competition can also destabilize the banking sector through its impact on the interbank market and the payments system. For example, if all banks are price-takers in a competitive market, banks have no incentives to provide liquidity to a troubled bank, leading to bank failure and creating negative repercussions for the entire sector (see Allen and Gale, 2000). A somewhat different argument in support of the competition-fragility view is that more concentrated banking systems have larger banks, which in turn allows them to diversify their portfolios better. A final argument in the competition-fragility view refers to the number of banks to be supervised by the authorities. If a more concentrated banking system implies a smaller number of banks, this might reduce the supervisory burden and thus enhance overall banking system stability. The competition-stability view argues that the notion that market power in banking boosts profits and bank stability ignores the potential impact of banks' market power on borrowers' behavior. Boyd and De Nicoló (2005) argue that since in less competitive sectors banks can charge higher interest rates, this may induce firms to assume greater risk, resulting in a higher probability that loans become non-performing. Similarly, higher interest rates might attract riskier borrowers through the adverse selection effect. Thus, in contrast to the charter-value hypothesis, Boyd, and De Nicoló (2005) predict that banks' actions will result in more risk-taking and greater fragility in more concentrated and less competitive banking systems. Advocates of the competition-stability view also disagree with the notion that concentrated banking systems characterized by few large banks are easier to monitor than less concentrated banking systems with many banks, since larger banks can be more complex and, hence, harder to supervise. The early empirical literature on the link between competition and stability is mixed. A number of country-specific studies have shown that increasing competition leads to greater individual bank risk-taking (see for example Keeley, 1990 and Dick, 2006, in the case of the US; Jimenez, Lopez and Saurina, 2007 in the case of Spain). However, at the same time, some studies have failed to find that larger banks are less likely to fail as would be predicted by the competition-fragility view (Boyd and Runkle, 1993; Boyd and Graham, 1991, 1996; De Nicoló, 2000) Recent papers using cross-country, time-series datasets offer evidence supporting the competition-stability view. Beck, Demirgüç-Kunt and Levine (2006 a,b) find that more competitive banking systems (defined as those with fewer regulatory restrictions on bank entry and activities) are less likely to suffer systemic banking distress. This finding is confirmed by Schaeck, Cihak, and Wolfe (2006), who find a negative relationship between bank competition and systemic bank fragility using the H-statistic to measure competition. Schaeck and Cihak (2007) identify bank capitalization as one of the channels through which competition fosters stability. Using data for more than 2,600 European banks, they show that banks have higher capital ratios in more competitive environments. This is consistent with Berger, Klapper and Turk-Ariss (2008), who find that banks in more competitive banking systems take greater lending risks, but compensate with a higher capital-asset ratio, resulting in an overall lower level of bank risk, as measured by the z-score. Measures of bank risk such as the z-score ignore systemic stability but regulators are concerned with systemic stability much more than with the absolute level of risk of individual banks. In a recent paper, Anginer, Demirguc-Kunt and Zhu (2011) introduce a new measure of systemic risk-taking by banks, measured as the total variation of changes in default risk of a given bank (as measured using Merton 1973 contingent claim pricing framework) explained by changes in default risk of all other banks in a given country. After controlling for various bank- and country-level variables, Anginer et al. (2011) find a positive relationship between competition and systemic stability. Overall, the advantages of competition for an efficient and inclusive financial system are significant. Furthermore, not only do recent studies suggest a positive link between competition and stability, but also policy bodies such as the OECD Competition Committee have suggested that to promote banking stability, policymakers should not use competition policy but rather should design and apply better regulations. See Beck (2008) for a thorough review of the theoretical and empirical literature on bank competition and stability. The authors also find a negative link between concentration and fragility. However, they conclude that the finding that competition reduces fragility when controlling for concentration suggests that something else besides a positive relationship between bank concentration and bank profits drives the negative link between concentration and fragility. They conclude that concentration might be an insufficient measure of bank competition. See

20 4. Banking competition and financial development
Lerner Index Across Developing Regions Source: High (low) competition is defined as the bottom (top) quartile of the country distribution of the Lerner index (country median across banks over the period ). Elaboration: GFDR Team

21 4. Banking competition and financial development
Industrial Countries Developing Countries Source: High (low) competition is defined as the bottom (top) quartile of the country distribution of the Lerner index (country median across banks over the period ). Elaboration: GFDR Team

22 5. Drivers of Banking Competition
Cross-section analysis of the drivers of banking competition Choice of drivers follows the literature (Claessens and Laeven, 2004; Anzoategui, Martinez-Pería and Rocha, 2010; Demirguc-Kunt and Martínez-Pería, 2010, among others) Focus on the role of the State As market participant. Presence of government-owned banks (GOBs) As regulator. Entry barriers to the industry Overall activity restrictions Transparency and disclosure requirements As enabler of a market-friendly environment. Overall strength of the institutional framework Quality of credit information

23 5. Drivers of banking competition Contestability and Institutional Framework
Note: The dependent variable is the Lerner index for the country computed over the period. Regressions were estimated using least squares with robust standard errors (White, 1980). Elaboration: GFDR Team

24 5. Drivers of Banking Competition Transparency and depth of credit information
Bank auditing requirements. We use the indicator of the strength of external audit (effectiveness of external audits) which summarizes information on: (a) external audit as a compulsory obligation for banks, (b) auditing practices for banks in accordance with international auditing standards, (c) requirement by the regulators that bank audits be publicly disclosed, (d) specific requirements for the extent or nature of the audit being spelled out, (d) auditors licensed and certified, (e) supervisors getting a copy of the auditor’s report, (f) supervisory agency have the right to meet with external auditors to discuss their report without the approval of the bank, (g) auditors required by law to communicate directly to the supervisory agency any presumed involvement of bank directors or senior managers in illicit activities, fraud, or insider abuse; (h) external auditors legally required to report to the supervisory agency any other information discovered in an audit that could jeopardize the health of a bank, and (i) supervisors taking legal action against external auditors for negligence. Bank disclosure. We use a measure of the transparency of bank financial statements. It comprises information on whether: (a) accrued, though unpaid, interest/principal enter the income statement while the loan is still performing, (b) accrued, though unpaid, interest/principal enter the income statement while the loan is still non-performing, (c) financial institutions required to produce consolidated accounts covering all bank and any nonk-bank financial subsidiaries (including affiliates of common holding companies), (d) off-balance sheet items disclosed to the public, (e) banks must disclose their risk management procedures to the public, (f) bank directors are legally liable if information disclosed is erroneous or misleading. Note: The dependent variable is the Lerner index for the country computed over the period. Regressions were estimated using least squares with robust standard errors (White, 1980). Elaboration: GFDR Team

25 5. Drivers of Banking Competition Inter-industry competition and market structure
Note: The dependent variable is the Lerner index for the country computed over the period. Regressions were estimated using least squares with robust standard errors (White, 1980). Elaboration: GFDR Team

26 5. Drivers of Banking Competition: Explaining differences in the Lerner index vis-à-vis High Performer Note: We report the explained differences in the Lerner index between the median values of the policy drivers for the selected developing regions vis-à-vis the higher performer in competition and its drivers. The high performer is computed as the top quartile of the overall sample distribution of the Lerner index and its determinants.

27 5. Banking Competition: Australia
Competitive dynamics altered by global financial crisis (GFC) Non-ADI lenders share loss in mortgage lending markets (securitization) Slower growth/ withdrawal of foreign banks’ operations Strong growth in deposits (supported government’s deposit guarantee) Rising use of long-term wholesale debt and reduced short-term exposure. Demand for deposits by ADI rather than short-term / long-term wholesale funding. Initiatives to improve competition Securitization markets. Government investment in RMBS (up to US$ 8 bn.) Account switching package. Lift impediments to customers’ ability to switch banks. Trade practices amendment Bill. It forbids the use of unfair terms in standard-form consumer contracts. Courts allowed to void unfair terms. National consumer credit protection reform (First phase) Licensing regime for providers of consumer credit and credit services. Responsible credit conduct obligations Expanded consumer protection through special court arrangements.

28 5. Banking Competition: South Africa
Banking Enquiry (Dec. 2006) initiated by the Competition Commission Focus: Retail banking Payment systems Disproportionate market power of Big 4 banks (despite not having 30+ % share in any product category) Very high cost structures (i.e. fixed and common costs) Product differentiation and price complexity are very high. Large information gaps Low customer switching Policy recommendations Purpose-designed regime for regulating non-banks’ access to payments system Establish regulator to determine need to inter-change any card/EFT transaction and regulating relevant fees. Regulating penalty fees for dishonored debit orders Replacing current inter-bank pricing model for automated cash machines with direct charging model (e.g. AUS) Introduce account switching codes to reduce costs of switching providers.

29 6. Additional background work for the Chapter
Anginer, Demirguc-Kunt and Zhu (2012) Reassess bank competition - systemic stability nexus Focus on systemic risk rather than risk of individual banks Banks take on more diversified risks with greater competition, and system is less vulnerable to shocks. Institutional and regulatory environment has a direct effect and an amplifying effect on systemic stability Calderón and Schaeck (2012) Policymakers calling for increasing competition in the aftermath of rescue operations during ongoing crisis (OECD, 2009; Independent Commission on Banking, 2011) Examine the effects of State interventions on banking competition Interventions: (a) blanket guarantees, (b) liquidity support, (c) recapitalization, and (d) nationalizations.

30 7. Conclusions and policy implications
Government may play a key role in enhancing competition in the financial sector Government should set up and implement policies that: Ensure greater market contestability Low barriers to entry and exit Promote deeper financial markets Development of NBFIs Promote bank transparency Role for market discipline Greater bank competition raises efficiency and soundness, and allows a more efficient resource allocation Competition per se does not generate financial instability in countries with robust institutional frameworks Harmful if regulations allow for excessive risk-taking Generous deposit insurance may elevate risk-taking incentives


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