Bank Competition: What is the Role of the Government?

Bank Competition:What is the Role of the Government? César Calderón (FPDCE), Maria Soledad MartínezPería (DECFP), Mauricio PinzónLatorre (FPDCE), Klaus Schaeck (Bangor University)

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

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.

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

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 certainconditions) • 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

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.

3. Trends in competition: Market concentration Asset share of 5 largest banks (CR5) Across Developing Regions, 1996-2010 (Average) Source: GFDR Team’s calculation based on data from Bankscope. Median values across country groups are reported.

3. Trends in Competition: Contestability Barriers to Entry Industrial vs. Developing Countries Share of denied licenses Industrial vs. Developing Countries • 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.

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.

3. Trends in Competition: H-Statistic H-Statistic: Industrialand Developing Countries • 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.

3. Trends in Competition: H-Statistic H-StatisticAcross Developing Regions, 1996-2007 • 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.

3. Trends in Competition: Lerner Index Annual Evolution: Industrial vs. Developing Countries Period averages: Industrial vs. Developing Countries • Source: GFDR Team’s calculation based on data from Bankscope following the methodology described in Demirguc-Kunt and MartínezPería (2010).

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

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 MartínezPería (2010).

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)

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).

4. Banking competition and financial development • Stability • Competing theories explaining competition-stability relationship • Competition-fragility viewpredicts 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 viewargues 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).

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.

4. Banking competition and financial development Lerner IndexAcross 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 1996-2010). Elaboration: GFDR Team

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 1996-2010). Elaboration: GFDR Team

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

5. Drivers of banking competition Contestability and Institutional Framework Note: The dependent variable is the Lerner index for the country computed over the 1996-2010 period. Regressions were estimated using least squares with robust standard errors (White, 1980). Elaboration: GFDR Team

5. Drivers of Banking Competition Transparency and depth of credit information • Note: The dependent variable is the Lerner index for the country computed over the 1996-2010 period. Regressions were estimated using least squares with robust standard errors (White, 1980). Elaboration: GFDR Team

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 1996-2010 period. Regressions were estimated using least squares with robust standard errors (White, 1980). Elaboration: GFDR Team

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.

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.

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.

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.

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

Bank Competition: What is the Role of the Government?