Market Power in retail banking and implications for the level and structure of charges

1. Market Power in retail banking and implications for the level and structure of charges Keith Weeks 15 October 2010

2. Introduction • Structure of retail banking in South Africa: • Market Shares and level of concentration • Barriers to entry • Sources of Market Power: • Product differentiation • Information Asymmetries • Search and Switching Costs • Rational Oligopoly behaviour: • Competition: Bertrand and Cournot • Horizontal restraints: agreements and concerted practices • Price shadowing • Strategic avoidance of price competition • Charging Practices of Banks • Relationship between fees and costs • Implications for competition

3. Structure of Retail Banking in South AfricaMarket Shares and Level of Concentration • National Treasury and the South African Reserve Bank on Competition in South African Banking (April 2004): “the concentration levels of the South African banking industry are high, but not out of line with other emerging markets. However, it is in the market segments rather than at firm level that concentration is even more marked. For example, while the Big Four (ABSA, First Rand, Nedcor and Standard) accounted for 83% of the total deposits of the public in June 2003, they accounted for 92% of mortgage loans and 89% of bank financed installment sales. Each of the Big Four has a scale monopoly (25% or more market share) in one or more of the retail market segments (credit cards, current accounts, mortgages or leasing and instalment sales).” • Technical Team analysis shows that this situation has not changed materially since 2004.

4. Structure of Retail Banking in South AfricaMarket Shares and Level of Concentration Table 1. Market shares for cluster of personal banking products in low income and middle income segments (average based on various sources)

5. Structure of Retail Banking in South AfricaMarket Shares and Level of Concentration Table 2. Market shares for personal transaction product segment (average based on various sources) and DI900 monetary value of month end balances.

6. Structure of Retail Banking in South AfricaMarket Shares and Level of Concentration • Figures not based on market definition, so individual banks’ market share of relevant anti-trust market not conclusive (cluster vs segment approach). • Retail banking sector is very concentrated regardless of how market is defined. • The four banks share more than 80% of the market – at the broad retail banking level and in the market segments. • Personal transactional account segment very concentrated – top four share approximately 90%.

7. Structure of Retail Banking in South AfricaBarriers to Entry High entry barriers – explicit and implicit Explicit: R250 Million required capital to become a registered bank and other costs of entry (e.g., high fixed costs, reputation barriers) Newly registered banks must obtain a SAMOS account with the SARB and membership of PASA and the Banking Association. Membership and usage fees to be paid to PASA and SAMOS and ultimately Bankserv or any other operator or association (like Mastercard and VISA). All of these are explicit costs that mount-up as a would-be entrant expands its participation in more payment streams. Implicit: Discretion of registrar in granting license and approval of existing clearing banks of new-entrant innovation in payment streams (danger of turf protection).

8. Structure of Retail Banking in South AfricaConclusions South African banking sector characterised as an oligopoly. Individual banks likely to have some degree of market power. Considerable scope for strategic interaction. However, these factors alone are not sufficient to conclude whether or not competition is working effectively. Competition analysis must probe whether market power of individual banks is appreciable and, if yes, implications for conduct and strategic interaction; and Scope for and extent of coordinated conduct (horizontal restraints/concerted practices). Taking all these factors into account: is competition likely to be effective given the likely rational behaviour of the banks?

9. Market Power Own-price elasticity of demand measures the extent to which a firm exercises market power. The more inelastic the price elasticity of demand the more likely the exercise of market power. Distinction between market demand curve and residual demand curve. As the number of firms increases, for a given market elasticity, the more elastic the demand of the single firm. So, in a market that becomes more concentrated, individual firms’ demand (residual demand) will be more inelastic. BUT: although this implies some market power it does not indicate whether it is appreciable.

10. Market Power Market power implies the ability of the firm to maintain prices above the competitive level. Depends on the elasticity of the firm’s residual demand curve. In addition to market shares and concentration this is influenced by: Barriers to entry Availability of substitute products and degree of product differentiation Asymmetry of information Costs of searching and switching. Strategic interaction between firms

11. Market Power The South African Competition Act defines market power as “the power of a firm to control prices, or to exclude competition or to behave to an appreciable extent independently of its competitors, customers or suppliers”. Section 7 of the Act: A firm is dominant in a market if – It has at least 45% of that market; It has at least 35%, but less than 45%, of that market, unless it can show that it does not have market power, or It has less than 35% of that market, but has market power.

12. Market Power OFT Guideline on Market Reference Inquiries: “A firm may have market power, and the capacity to act in ways that may restrict or distort competition, with a market share below that usually regarded as necessary to suggest dominance for the purposes of CA98. Much will depend on the constraints exerted by its competitors or its customers”. Important factors constraining or facilitating market power that will be discussed here: product differentiation, information asymmetries, search and switch costs.

13. Market PowerProduct Differentiation Horizontal product differentiation – relates to different preferences of consumers. Vertical product differentiation – relates to differences in the quality of products (real or perceived). Product differentiation dampens the degree of price competition between firms by making the residual demand curve of each firm less elastic. Therefore, does confer some degree of market power on the differentiating firm. Pro-competitive to the extent of meeting a variety of customer preferences and needs, and Innovation and quality improvements rewarded

14. Sources of Market PowerProduct Differentiation Elements of horizontal and vertical product differentiation in banking. E.g., expenditure on “top-of mind” advertising a form of vertical differentiation. Suggests that banks’ can influence consumers’ willingness to pay (also dependent on income levels of consumers). Horizontal differentiation reflected in different packages and product bundles targeted at different customer segments

15. Sources of Market PowerProduct Differentiation However, intrinsic horizontal differentiation may in fact be limited. Bank is multi-product firm E.g.: Transactional banking – consists of a bundle of features for which customers’ are charged. Farrell and Klemperer note, “selling an extra variety can attract demand away from rival suppliers for this firm’s existing varieties”* So, all the multi-product oligopolists will tend to offer similar products and product lines. Each bank may offer many features on the transactional product but, intrinsically, there will not necessarily be much variety produced by the industry as a whole*. *Farrel J and Klemperer P (2006) Coordination and Lock-In: Competition with Switching Costs and Network Effects, from www.paulklemperer.org

16. Sources of Market PowerInformation Asymmetries When customers have sufficient information they are able to use this information to make efficient and rational choices. However, when firms have more information than their customers about the attributes of their products, this information asymmetry confers on these suppliers a degree of market power over their customers. In SA banking sector there are significant information asymmetries that prejudice consumers. This is particularly true in the case of personal transaction accounts. There are a bewildering array of different packages and bundled offerings with complicated fee structures

17. Sources of Market PowerInformation Asymmetries Technical team experienced considerable difficulties in trying to compare the different offerings, both within and across banks. Submissions by consumers and other anecdotal information tells a similar story. The wide array of packages and bundled offerings complicate choices for customers but do not seem to reflect intrinsic horizontal product differentiation between the banks. This may have a significant dampening effect on the extent of price competition. Consumers may also not be sufficiently informed to be able to choose between differentiated offerings on the basis of positive criteria other than price

18. Sources of Market PowerSearch and Switch Costs Wilson, Charles, M. 2006., Markets with Search and Switching Costs, MPRA Paper No. 131. http://mpra.ub.uni-muenchen.de/131: “Search costs are the total costs spent by a consumer in identifying and interpreting a firms product and price offering, regardless of whether the consumer buys the product from that firm or not. Switching costs are the total costs incurred by a fully informed consumer through deciding to change suppliers that would not have been incurred by remaining with the current supplier”

19. Sources of Market PowerSearch and Switching Costs Wilson notes further: “Due to the assumption that search costs, unlike switching costs, are incurred unconditionally on the decision to switch suppliers it is shown that the anticompetitive effects of search costs are consistently larger than those from an equivalent level of switching costs. The finding suggests that obfuscation practices that aim to deter customers from switching, such as competing on deliberately complex tariffs, may be particularly powerful relative to practices that increase the costs of substitution between firms.”

20. Sources of Market PowerSearch and Switching Costs Complicated packages and bundled offerings suggest significant search costs re: transactional product offerings. Switching costs: Competition tends to be more robust when consumers are able to easily switch from one supplier to another in response to a competitive price or some other factor that offers the customer better value for money. However, when customers are restricted from switching due to inconvenience, administrative hurdles, monetary costs, and/or other factors, competition may be inhibited.

21. Sources of Market PowerSearch and Switching Costs Banks have argued that switching costs are not a significant barrier. Refer to churn figures which are higher in South Africa relative to other countries. Higher churn does not really tell us anything about the effectiveness of competition in bringing about switching. Search costs may dampen price competition, despite higher churn figures. Churn figures greater in the lower income segments i.e., Mzansi Reasons? Account abandonment? Lower switching costs associated simplified product offerings? Opportunity cost of time lower for Mzansi customers?

22. Rational Oligopoly BehaviourCournot& Bertrand Competition Although firms in an oligopoly may recognize their interdependence this alone does not mean they will not compete. Cournot: firm competes by setting output, given the output of its rivals. With Cournot type competition price will be greater than marginal cost – but difference between price and MC reduce as the number of firms increase. Bertrand: firms compete by setting price, given prices of rivals

23. Rational Oligopoly BehaviourCournot& Bertrand Competition In simple Bertrand model (even with only two firms) outcome is similar to perfect competition (P=MC). But simple Bertrand model is not realistic. Assumes homogenous products. If one introduces product differentiation, then price will exceed marginal cost. However, the fact that price is greater than marginal cost does not mean that there will not be effective competition. Must consider other factors contributing to market power of firms and nature of oligopoly interaction

24. Rational Oligopoly BehaviourHorizontal Restraints Where firms recognize their interdependence they may have an incentive to not act independently but coordinate their conduct (either by direct agreement or indirectly through some other arrangement) in order to restrict or prevent competition. There is no evidence of collusion in the setting of fees and charges on transactional products. However, there is concern that arrangements among the banks in certain payment streams may restrict competition. In the case of ATMs and payment cards there appear to be arrangements among the banks which may serve as a basis to introduce restrictions which may inhibit competition. E.g., Absence of direct charging for ATM withdrawals and restrictions on entry of non-bank providers restricts the extent to which ATM fees can be competed down.

25. Rational Oligopoly BehaviourPrice Shadowing Firms will either shadow one another’s pricing upwards or will follow a price leader who tends to set a ‘price umbrella’ under which firms can safely keep their prices up at an above-competitive level. Firms who are aware of their strategic interdependence can achieve this outcome without the need for any kind of coordination – they are able to act unilaterally to implement their best strategy in order to maximize profits. Our analysis of transaction fees is not conclusive. In some cases fees diverge considerably across banks whereas in other cases there are parallel movements. However, price following not unprecedented in SA banking: Standard Bank ATM carriage fee adjustment in 1997, and Banks’ responses to repo rate adjustments

26. Rational Oligopoly BehaviourStrategic avoidance of price competition Recent developments in the economics of search and switching costs tell an interesting story about the incentives of firms in oligopoly markets where such costs are present. In such cases firms may have an incentive to gain and extend market power by making it difficult for customers to shop around and switch to more competitive offerings or by disrupting or preventing any standardization or compatibility of offerings that would otherwise facilitate switching and price competition. We have noted in previous slides the prevalence of information asymmetries, search and switching costs in the South African banking sector – all factors which facilitate strategic avoidance of price competition by oligopoly firms.

27. Effectiveness of Competition in South African Banking There are a number of factors that may inhibit effective competition in retail banking in South Africa. Primary among these are: The information asymmetries that arise out of inadequate disclosure of product and price information to customers; Significant costs of searching that arise out of the complicated packages and fee structures – making it difficult for customers to shop around and make efficient and rational choices; and Switching costs, which act as a barrier to customers moving from their current provider to a more competitive alternative.

28. Charging Practices of Banks Unbundled (pay as you transact options) Flat fees (fixed amount per transaction) Ad valorem fees (One, Two, Three part formula) Banded Fee Options (to simplify three part formula) Ad valorem pricing rationale: risk associated with the transaction increases as the transaction value increases. Benefit to consumers: allows banks to lower their fees to customers making low value transactions..BUT no cost justification. Unbundled pay as you transact options have involved higher fees on average being paid by customers transacting on that basis Bundled Package Options Fixed monthly fee for a bundle of transactions Facilitates comparisons and may be cheaper if used “as intended” However customers often severely penalized as a consequence of charges incurred for out of bundle transactions. CAPITEC: “many complaints are lodged by the public about high bank fees. More simplified comparative models may be needed to enable financially unsophisticated clients to compare bank fees”

29. Relationship between fees and cost Multiproduct – objective difficulties in measuring costs of individual transactions Clear that banks engage in “value-based pricing”: Depends on the product or service being sufficiently differentiated from its rivals so as to enable a degree of market power to be exercised in the suppliers pricing decisions. It makes conscious and systematic the identification of what different customers or segments of customers can be expected to bear: “differentiated pricing which seeks to segment customers into groupings based largely on patterns of usage and according to income levels. Banks will implement price structures and set price levels which they calculate will maximize profit generated from customers transacting across the different channels. Costing information plays a role to the extent that banks must check whether revenue is sufficient to cover overall costs…no consideration is given to the costs of specific transactions…”

30. Implications for competition Given the extent of differentiation there appears to be little scope for price competition….an inherent feature of oligopoly No reference to actual costs of transactions in the past suggests a lack of effective competitive pressure.. However with developments in technology banks have indicated a move towards measures to calculate costs more accurately at the transaction level.. Combination of factors to promote greater competition and alignment of fees with costs: New entry and expansion of “fringe players” (e.g Capitec…FNB response) Promote switching through switching code and reducing barriers to switching Reduce search costs through better disclosure and improved comparability Financial literacy and “consumer activism” to reduce information assymetries..