Market entry, privatisation and bank performance in transition Steven Fries, Damien Neven, Paul Seabright and Anita Taci EIASM Workshop on Financial Development Prague, 26 May 2006

Introduction Many policies used to change socialist banking systems into market-oriented ones, including –Restructuring and privatisation of state banks –Entry of new private banks, including foreign Gauge impact of reforms on banking development by examining revenue and costs –Foreign banks are low marginal cost entrants –Privatised banks attract greater demand –Differences among private banks diminish over time –State banks under perform on both demand and costs

Approach of the paper Develop unique model of monopolistic competition in bank lending and deposit taking to analyse revenues –Look for effects of market entry and ownership on deposit and loan margins Use standard trans-log specification for costs –Estimate marginal costs by ownership type Compare margins and marginal costs for mark-ups –Indicates ability to attract demand for loans and deposits Allow parameters of revenues and costs to vary over time

Existing literature Banking market structures in transition economies (TEs) –Gelos and Roldós (2002), Yildirim and Philippatos (2002a) and Drakos and Konstantinou (2003) –Evidence of monopolistically competitive markets –Increasing competition over time Cost / profit efficiency of banks in TEs –Grigorian and Manole (2002), Yildirim and Philippatos (2002b), Bonin, Hasan and Wachtel (2005) and Fries and Taci (2005) –Greater efficiency of foreign banks

Existing literature (cont’d) Determinants of bank net interest margins in TEs –Drakos (2003) –State-owned banks have relatively low margins Theoretical models of imperfect competition and institutional development in TEs –Hainz (2003a, 2003b) –Studies show that the market power of banks decreases as the quality of institutions improves

The starting point: bank profit function Accounting identityLoanmarginDepositmargin Non-loan assets margin Operating costs Interbank rate  i  r i l L i - r i d D i + r i n N i - R(L i + N i - E i - D i ) - C(D i,N i,L i,W i )  i  (r i l - R)L i + (R - r i d )D i + (r i n - R)N i + Re i - C(D i,N i,L i,W i ) Equilibrium determination of loan and deposit margins in monopolistically competitive markets

The empirical specification Revenue function is therefore Margins are a function of number of competitors, market shares and bank ownership REV ijt = M ijt l ( )L ikt + M ijt d ( )D ikt + ρN ijt + σE ijt +  ijt REV ijt = M ijt l+d ( )(L ikt + D ikt ) + ρN ijt + σE ijt + ε ijt Combine loans and deposits into a single scale variable because of their co-linearity

Empirical specification (cont’d) Trans-log specification for costs Higher order terms omitted because they were insignificant in preliminary estimations Allow estimated constants to vary by bank ownership and over time Identifies differences in average costs across bank types lnC ijt = α o + Σ s t β s lnQ s,ijt + Σ m n X m lnW m,ijt

Dataset Bankscope database for accounting data –477 banks in 15 transition economies –Sample period covers 1995 – 2004 –Unbalanced panel, 115 banks for entire sample period Unique coverage of bank ownership –Time varying measures of ownership based on EBRD staff research –Newly established, privatised and state-owned –Domestic and foreign

Basic data on bank revenues Revenues to total assets in per cent

Basic data on bank costs Operating costs to total assets in per cent

Results – Revenue equation (revenue adjusted for inflation) Explanatory variables Interacted with loans plus deposits Loans Newly established, domestic Newly established, foreign Privatised, domestic Privatised, foreign Number of banks per million of population Share of loan and deposit market IAS dummy variable *** Deposits Non-Loan financial assets Equity *** *** *** *** *** ** *** *** *** *** *** ** ** *** *** *** *** *** *** * ** *** *** *** ***

Results – Cost equation Ln (loans + deposits) Ln (loans + deposits ^ 2 Ln (operating costs / total assets) Ln (operating costs / total assets) ^ 2 Ln (non-loan financial assets) Equity to total assets ratio Newly established, domestic Newly established, foreign Privatised, domestic Privatised, foreign *** *** *** *** *** *** *** *** *** *** *** * *** ** *** * *** **

Marginal costs and mark-ups Foreign bank marginal costs below that of state bank

Marginal costs and mark-ups Mark-ups above state bank benchmark

Foreign banks are low marginal cost entrants Privatised banks attract greater demand –Evidence that newly established banks attract more demand with a lag New domestic banks had weaker performance than other private banks –While differences diminish over time, this casts doubts on liberal entry policies for domestic banks State banks are the weakest performers throughout Policy implications –Openness to foreign entry (costs) and privatisation of state banks to both domestic and foreign owners (demand) Conclusion