1. Topic 8 – Competitive Issues in Banking

2. Competitive Issues in Banking Outline  Output Measurement  Productivity Measurement  Economies of Scale and Scope  S-C-P vs Efficient Market Hypothesis

3. Measurement of Bank Output Output produced by financial institutions is difficult to determine due to problems identifying quantities of measurement. Difficult to account for quality in a banking service.  i.e. an ATM may improve the quality of payment services as well reduce a customer’s transaction cost – difficult to measure. Two common approaches:  The production approach  The intermediation approach

4. The Production Approach Banks are treated as firms for measuring output.  Banks use capital and labour to produce deposits and loan accounts and output is measured as the number of accounts/number of transactions per account. Problems:  How to weight each of the bank’s services in the computation of output?  Unlikely to find comparable quality data from different banks – comparison is difficult.

5. The Intermediation Approach This approach recognises intermediation as the core activity.  Output is measured by the value of loans and investments.  Cost is measured as operating cost plus deposits. Most bank productivity studies used intermediation approach.  Fewer data problems  Universal Banking?

6. Productivity Measures Two types of productivity measures are used.  Partial  Total Partial measures are based on financial ratios (coursework). Total measures take into account the multiple nature of outputs and inputs in banking. One such measure is total factor productivity (TFP).

7. Total Factor Productivity TFP employs a single productivity ratio by using multiple inputs and outputs. The widely used TFP measure is data envelopment analysis (DEA).  DEA compares the observable outputs (y jp ) and inputs (x ip ) of several banks. It then identifies the relatively most efficient bank (and therefore the relatively less efficient banks.) To do this, it maximises the following:

8. Total Factor Productivity The model is run repetitively with each bank appearing in the objective function once to derive individual efficiency rating. The decision about efficiency or inefficiency is based on the following:  E=1 ‘efficient’  E<1 relatively inefficient However, ‘efficient’ does not mean efficient in absolute terms but efficient compared to other banks in the data set.

9. Economies of Scale Economies of scale : Long-run concept where all the factor inputs can be varied. A bank exhibits scale economies if an increase in factor inputs yields a greater than proportionate increase in output  the bank is operating on the falling portion of their average cost curve

10. Economies of Scale Consider a bank with three factors of inputs capital (deposits), labour (bank employees) and property (branch network). The bank produces one output (loans). Economies of scale are said to exist if, as a result of doubling each of three inputs, the bank is able to more than double its loan portfolio. In practice, even this simple example is problematic, b/c all factor inputs are not variable to the same extent (e.g. it is difficult to double deposits).

11. Economies of Scale If inputs are doubled and loans are doubled, then risk portfolio is bound to change (shareholder wealth). All this implies that it is difficult to apply the concept of economies of scale in financial sector. Hence it calls into question the underlying concept of mergers and acquisition – the hope for economies of scale and scope.

12. Economies of Scope Economies of scope exist if the joint production cost of producing two or more outputs is lower than if the products are produced separately. For example a bank offers three services to customers (deposits, loans and payment services). If the bank can supply these services more cheaply through a joint production process than producing and supplying them independently, it is said to be enjoying economies of scope.

13. Strategic Inference Evidence of economies of scale will mean large banks have a cost advantage over small banks. If synergy is present, universal banks will be more profitable than traditional banks.

14. Structure-Conduct-Performance Model states that a change in the market structure or concentration of the banking sector affects the way banks behave and perform. Market structure is determined by the interaction of cost (supply) and demand.

15. Structure-Conduct-Performance Conduct (decisions on prices, levels of advertising etc.) is a function of number of sellers and buyers, barriers to entry and cost structure. The outcome is market performance (profitability). In simple words less number of firms (structure: high concentration), higher prices (conduct) and higher profit (performance)

16. Efficient Market Hypothesis Some banks earn supernormal profit b/c they are more efficient than others. The relative efficiency model predicts the same positive profit-concentration relationship as the SCP model. However, the positive relationship is not explained by collusive and abusive behaviour (as with SCP), but greater efficiency (and hence concentration).

17. Strategic Inference According to SCP, concentration is exogenous, resulting in higher prices for consumers and higher bank profitability. In the relative efficiency model, exogenous bank specific efficiencies results in more concentrated markets. If the relative efficiency model is found to hold, it would suggest markets are best left alone.