Economics of Market Power: the case of

Banking

By
Bhuvan Sethi
University of Strathclyde
Glasgow, U.K
September 2006

MSc. Economic Management and Policy.

Abstract
Following financial de-regulation and liberalization, there has been a notable increase
in competition among banks. Contrary to popular beliefs, this increased intensity of
competition in banking markets has exposed certain structural weaknesses, which
makes the banking sector sensitive to the extent of competition in the market. In light of
such arguments, the debate on the appropriate level of competition among banks has
essentially turned into a trade-off. While textbook wisdom suggests that a competitive
banking regime maximizes efficiency and thus growth, stability, achieved through
market power, is also necessary to avoid systematic runs and failures. This paper
reviews theoretical and empirical literature on modern financial intermediation
analysis and industrial organization of banking to study this supposed trade-off.
Recent studies point out to a rather interesting conclusion. That is trade-off exists is not
certain. Market power in banking can bring out the desired efficiency effects by
allowing banks to build a safe loan portfolio and thus enhance stability. Studies also
point towards the active role of regulators in promoting competitive behavior
(contestability) in the market by allowing banks to diversify and by easing entry
restrictions in order to neutralize the negative effects of market power. In turn, it is
suggested that a sound banking system should ideally resemble a market structure
which promotes competition among few or in other words bear resemblance to an
oligopolistic market structure. This paper also highlights some important policy
implications.

Table of contents.

Chapter 1: Introduction ............................................................................................................. 6

Chapter 2: Contemporary Banking Theory............................................................................. 11
Introduction: ............................................................................................................................ 11
2.2: why do banks exist? ......................................................................................................... 14
2.2.1: transaction costs explanation ........................................................................................ 15
2.2.2: Ex-Ante Information Asymmetries .............................................................................. 16
2.2.3: Ex-Post Informational Asymmetries ............................................................................ 17
2.3: An Extra Perspective on the Theory of Financial Intermediation ................................... 20
2.3.2: How do Banks Create Value. ........................................................................................ 22
2.4: Do all theories of financial intermediation contradict each other? .................................. 23
2.5: Some final remarks .......................................................................................................... 24
Chapter 3: Competition among banks-good or bad ................................................................ 26
3.1: The Debate Started- Competition and Banking ............................................................... 29
3.2: Stability vs. Efficiency Part II- Market power and Banking ........................................... 34
3.2.1: Market Power and Banking- The Debate Continued. ................................................... 39
3.2.2: Entry Barriers in Banking ............................................................................................. 40
3.3.3: Monopoly and Banking ................................................................................................ 43
3.3: Stability vs. Efficiency Part III-Oligopoly and Banking ................................................. 45
3.4: Stability vs. Efficiency Part IV- Debate Concluded ........................................................ 47
Chapter 4: empirical evidence ................................................................................................ 49
4.1: Stability vs. Efficiency- empirical evidence .................................................................... 50
4.2: Structural Approaches to Competition and Banking ....................................................... 54
4.3: Non-Structural Approach to Competition and Banking .................................................. 57
Section 4.3.1: The Panzar and Rosse approach. ..................................................................... 57
Section 4.4: Some final thoughts ............................................................................................ 61
Chapter 5: debate concluded ................................................................................................... 62
References:.............................................................................................................................. 66

Acknowledgement
I would like to thank my friends; family members and everyone at the Department of
Economics, University of Strathclyde for providing support and motivation throughout this
piece of work.

A special thanks to Mr. John Scouller for his support and guidance throughout the project.

() we
believe that imperfect
competition is an important,
although somewhat neglected
aspect of banking
Matutes and Vives, 2000

() has the pendulum moved too far towards unleashing

competitive forces in banking?
Vives, 2001

() the time is ripe for an open

debate regarding the costs and
benefits of bank competition
Nicola Cetorelli, 2001

Chapter 1: Introduction
A small town on the west coast of United States of Nowhere called Old York boasted of a
healthy, hard working population of about five hundred thousand. The town, like many
others around the world, had all the modern amenities including a bank called Only Bank.
This bank was the only financial intermediary in town responsible of channeling savings to
productive investments through the supply of credit to businesses and households. Young
firms and entrepreneurs, with no past corporate history, would seek the banks help in raising
seed capital necessary to get their business started. The bank, fully aware of its position,
took its own time in screening applicants and deciding whether to extend the loan or not
depending on the respective project and the credit risk.
The citizens of Old York were seemingly unhappy with the banks behavior. The lenders
complained of getting lower than equilibrium returns on their deposits, while the borrowers
complained of restricted access, slow service and higher than equilibrium interest rates on
loans. The only entity happy about this situation was Only Bank. With lower than industry
level non performing loans assets and the ability to charge a price above marginal costs- the
bank boasted of a balance sheet, which would make any analyst on Tall Street fall in love
with it. Two questions were being asked however.

Could Only Bank be reasonably accused of socially harmful monopoly practices?

Is excessive screening and monitoring of loan applicants good or bad for the
economy?

Smelling the vast opportunities this small town had to offer, a lot of banks from all over the
country set shop in Old York. Soon this quite and peaceful town was turned into a
corporate battlefield. Young bankers, armed with professional degrees, were chasing
customers offering deals too good to be true. No one was complaining, lenders got
competitive returns on their deposits, while the borrowers, even the ones rejected by Only
Bank, managed to secure credit at unbelievably low rates. The town was buzzing with
activity and market share became the new mantra for banks. Only Bank, seeing no other
6

alternative, joined the band wagon. All the banks in the area were now profit maximizing
price takers supplying the greatest amount of credit at the lowest prices. New questions
began to be asked.

Is a lot of competition among banks socially desirable?

Is no or limited screening and monitoring of applicants good or bad for the

economy?

What impact would this situation have on the banks balance sheet?

As time went by, a lot of debtors, owing to failure of start-ups or insufficient profits to payback, defaulted. On the consumer side, customers, who were issued credit cards without
looking into their ability to pay-back, suddenly realized they had spent more than they can
afford. The possibility of a mass default was very real. The whole banking sector in Old
York was in a mess. Realizing the grave danger this situation posed for the whole economy
of Old York, the regulator acted fast to get the situation under control. Overnight sweeping
changes were brought about in legislation encouraging mergers and acquisitions in the
banking industry. The aim was to reduce the number of banks to a few Big Ones ensuring
stability along with efficiency brought about by Oligopoly competition.

Is competition among few the optimum banking structures for an economy?

What role do regulators play in ensuring a fair and competitive banking sector?

A More Formal Introduction:

Although Old York in United States of Nowhere and Only Bank might not exist in real
world, issues regarding the nature and significance of competition in the banking sector are
gaining ground both in relevance and importance. To start with, such a debate may seem
unwarranted for. Applying welfare theorems would predict that a perfectly competitive
banking system would maximize efficiency and so be welfare enhancing. Market power, on

the other hand, would induce a dead weight loss on the society by allowing banks to exercise
their market power and thus encourage them into charging a higher loan rate to businesses
and by giving out lower deposit rates to retail investors. Such an action would have a
dampening effect on entrepreneurial activities and also cause firms to scale down on their
R&D initiatives. Allowing higher than competitive loan rates would also bring about a
preference shift in borrowers from risk neutral projects to risky projects (since higher risk
entails higher returns), thereby weakening the overall resilience of credit markets. All this
would eventually result in an economy acquiring a slower pace of capital accumulation and
therefore diverging from the more important social goal of achieving highest per capita
income for the state.

However, research, in more recent years, has brought to light some additional issues
regarding the overall costs and benefits of bank competition on an economy. In particular, the
nature of the industry, its complex linkages with the economy and issues regarding
information economics have highlighted the need for striking a fine balance between
financial stability and competition in financial markets. In an important contribution, Keeley
(1990) revealed that though de-regulation of the financial sector in the U.S during 1970s and
80s led to reduction in monopoly rents for banks, increased competition also led to a
noticeable increase in bank failures during that period. Such an incidence was not only
restricted to the U.S but also included other countries where empirical studies have found a
significant relation between competition and financial instability. Various other studies1,
using data on as many as 70 countries, have found the relationship between competition and
financial instability to hold true. Also, the cost of such an event can be high, particularly for
emerging and less developed economies. Hoggarth and Saporta (2001)2 find the average
fiscal cost of bank crises across countries to be 16% of world G.D.P, with a higher cost of
such crises for emerging economies. Table 1 below outlines the costs of banking crises
across different countries.

1
2

Other studies are done by Beck, Demirguc-Kunt and Levine (2003), Bikker and Haaf (2002)
Since this source is not freely available, reference is taken from Allen and Gale (2003)

Table 1: (Source: Allen and Gale 2003)

Readers of this paper would have by now sensed the issues at stake. Over the years,
following mass liberalization and financial de-regulation, a vast amount of literature has
emerged debating on the role of excessive competition in the Banking Industry, a sign that
the time is ripe for an open debate regarding the costs and benefits of bank competition
(Cetorelli 2001). Indeed this is the subject matter of this paper Economics of Market
Power: the case of Banking.

Chapter 2 outlines the Contemporary Banking Theory. The chapter would start by defining
financial intermediarys in general and banks in particular and would then go on to look at
reasons why banks exist. The second half of the chapter would examine the intricate details

of this sector highlighting its importance to the economy and issues such as moral hazard,
adverse selection and the need for screening and monitoring.
Chapter 3 would build on the previous chapter and focus on issues relating to market
competition in the banking sector. In particular, the chapter would argue why a certain degree
of market power might be beneficial for the banking sector and how it (market power) can
create both stability and efficiency.

Chapter 4 reviews the empirical evidence provided on this subject, looking at both, the
structural and non-structural approaches to competition in banking.

Chapter 5 concludes the debate.

10

Chapter 2: Contemporary

Banking Theory

Introduction:
Moving away from our imaginary world of Only bank into the real world; this chapter talks
about banking theory in a contemporary framework. Traditionally (up until the late 1960s)
economic theory and analysis failed to recognize the importance of financial intermediation3.
The design of the financial sector was thought to be of no major importance for economic
decision making and was thought to produce nothing but a veil over the true determinants of
economic development (Theil 2001).

Generally speaking, the early literature on microeconomics (like Patinkin, 1956) failed to
recognize the importance of financial intermediaries as it came to light under the auspices of
perfect markets and complete information. In fact under the traditional Arrow- Debreu model
of resource allocation, banks seemed to be no more than redundant institutions. This came
about as in the Arrow-Debreu world, savers and investors costlessly found each other since
they had perfect information on each others choices and so did not need intermediation
services to exchange savings in return for financial products. Also, the Arrow-Debreu world
assumed no transactions or search costs to be involved in such an exercise and hence found
the needs of both investors and borrowers to be met fully and simultaneously. With the
result, present value prices of investment projects became well defined and so banks as a
decision making agency had no impact on other agents.

However, with the emergence of a new paradigm: the asymmetric information paradigm,
economic theory on banking has entered a process of change that has overturned economists
traditional vision of the banking sector. Revolving around the assumption that different
agents possess unique bits of information on various economic variables and that the agents
use this information for self profit maximization, asymmetric information paradigm has
helped explain the role of banks in the economy and highlighted the structural problems in
3

Financial intermediary and banks would be used interchangeably in this chapter.

11

the banking sector (like financial contagion and susceptibility to runs and panic) that may
justify public intervention.

The current chapter, thus building on the new paradigms, addresses issues regarding what
banks are? What do they do? And why do they exist? This, in my view, is an important first
step towards analyzing the bigger issue, that of the appropriate level of competition in the
banking industry. From the view point of the society, every competition model (textbook
models on perfect competition, monopoly and oligopoly) has some positive as well as
negative aspects around it and to be able to judge or comment on the optimal market
structure for any industry, a necessary precondition is to be aware of the industry
characteristics. This is what the aim of this chapter is.

Section 2.1 starts off by defining a bank and then goes on to consider what they do. Section
2.2 discusses the traditional theories of financial intermediation. Section 2.3 considers a new
line of research on banks. Section 2.4 comments on the different theories of financial
intermediation. Section 2.5 leaves some final remarks, emphasizing the significance of all
this for our view of competition in banking sector.

2.1: What is a Bank and What do Banks do?

In crude terms, banks can be defined as entities that channel funds from savers to borrowers
and transfer returns from borrowers back to savers. However a more formal definition, one
used by the regulators, is also available: a bank is an institution whose current operations
consist in granting loans and receiving deposits from the public (Freixas and Rochet,
1997). This formal definition has two important aspects to it. Firstly, the word current is
important because most industrial or commercial firms occasionally lend money to their
customers or borrow from their suppliers. Secondly, the fact that both loans and deposits are
offered is important because it is the combination of lending and borrowing that is typical of
commercial banks.

12

Historically, the existence of banks is justified by the role they play in facilitating intertemporal allocation of household consumption and by allocating physical capital to its most
productive use in the business sector. If someone would have asked twenty years ago: how
financial intermediation improves resource allocation? The answer would have been by
lowering transaction costs; however with advances in both banking theory and information
economics, today transaction costs would be identified with only a fraction of what banks are
supposed to do. Apart from the well established functions banks perform like Liquidity and
Payment Services, Money Changing, Payment services, Managing Risk, Managing Interest
Rate and Liquidity Risk, Off-Balance-Sheet Operations and Resource Allocation, banks also
play a role in Asset Transformation and Monitoring and Information Processing. Figure 2
lays down the functions of a Financial Intermediary.

Figure 1 (Source: Bhattacharya and Thakor, 1993)

13

2.2: why do banks exist?

Recall from the previous section, where we defined a bank as an institution whose current
operations consist in granting loans and receiving deposits from the public. Now, an alternate
version of this definition in terms of defining a Financial Intermediary (FI) in general can be
that of an economic agent who specializes in the activities of buying (buy the securities
issued by borrowers i.e. grant loans) and selling (selling the same securities to lenders i.e.
collect deposits) (Frexias and Rochet, 1997). Both the definitions stated above are quite
similar in nature to the notion of intermediaries in the theory of Industrial Organization. The
justification given by the theory of Industrial Organization to the existence of such
intermediaries is simply the presence of frictions in transaction technologies (For example,
Brokers and Dealers operating in financial markets).

However, banking activities are in general more complex, for at least two reasons:

Banks usually deal (at least partially) with financial contracts (loans and deposits),
which cannot be easily resold, as opposed to financial securities (stocks and bonds),
which enjoy a flourishing secondary market. Therefore banks typically, must hold
these contracts in their balance sheets until the contract expires.

The characteristics of the contracts or securities issued by firms (short-term or longterm loans) are usually different from those of the contracts or securities desired by
investors (time deposits etc.).

Thus as figure 2 above and research by the likes of Gurley and Shaw (1960) and more
recently by Fama (1980) suggests, banks are there to transform financial contracts and
securities to suit the needs of the investor class both on the demand side and the supply side.
Of course, in the Arrow- Debreu world, as discussed above, one would not feel the need for
such an intermediary since both investors and borrowers would be able to diversify perfectly
and obtain optimal risk sharing. But as soon as one takes into account even the smallest of
deviations from this ideal world and considers the so called frictions in the transaction

14

technologies, financial intermediaries in general and banks in particular are needed. The
following sub sections dwell on such explanations for the existence of banks in an economy.

2.2.1: Transaction costs explanation

Transaction costs explanation is one of the standing pillars on which the early literature on
banking was established4. According to the views held at that time, banks were considered to
be mere asset transformers, transforming deposits of convenient maturity, such as demand
deposits into non marketed loans with a longer maturity and in large amounts with more risk.
And in performing the role of an intermediary as an independent unit, banks were able to
attain economies of scale and scope5.

However, microeconomics of banking, per se, cannot be established totally on such grounds.
Even if historically physical and technological costs have played an important role in the
emergence of FIs, it should be kept in mind that these costs are given exogenously. With the
progress experienced recently in telecommunication and computers, as well as related
advances in financial instruments have all undermined the basis of such arguments. Though
at a nascent stage, firms, governments and people alike have realized huge efficiency gains
from E-business and the concept is surely to grow. By producing real-time information and
by providing a common ground to both producers and consumers, e-business has slowly
started to change the way firms do business and has threatened the very existence of
intermediaries in traditional industries. A successful example of such new practices can be
internet portals such as E-bay and Amazon etc. which have provided a common ground to
both suppliers and consumers, eliminating the need for an intermediary.
The point here is that unless a more fundamental form of transaction costs is not present,
FIs are bound to disappear. (Freixas&Rochet, 1997). As I had mentioned in the start of this
chapter, asymmetric information has played an important role in helping to build a theory on
4

For detailed study, readers can refer to Benston, G and C.W. Smith.(1976)
For example, fixed costs of asset evaluation mean that intermediaries have an advantage over individuals
because they allow such costs to be shared. A more detailed study on such scale economies can also be found in
Freixas and Rochet, 1997 pg 18-20
5

15

banking and shown ways to overcome the market imperfections generated by such
asymmetries. It would thus only be logical to find answers to our questions based on such
concepts. The two topics explored in the following sub sections are Adverse Selection (exante) and Costly State Verification (ex-post).

2.2.2: Ex-Ante Information Asymmetries

First conceived by an American economist, George Akerlof in the 1970s, adverse selection
refers to a situation wherein the marketplace would generally contain poor quality products if
buyers are not able to accurately judge the product quality. Akerlof (1970) demonstrated that
in the presence of asymmetric information, equilibrium no longer requires supply to equal
demand and can cause markets to vanish completely.

To seek justification for the existence of banks while considering the adverse selection
paradigm, consider a situation where no bank exists. Now, a large number of entrepreneurs
are there in an economy who, although can afford to fund their projects, would like to borrow
money from investors. Investors on the other hand have limited information on the viability
of the project in a sense that some information about the project is privately held by
borrowers and that entrepreneurs are indistinguishable by investors. In a situation like this,
what options do the investors have in order to gauge the success of the project in question?

In a seminal contribution, Leland and Pyle (1977) demonstrate that borrowers can signal
about the viability of their project through Self Financing. This conclusion seems logical.
After all if a borrower is willing to part finance the project then in a sense he is sending a
positive message to the investor class about the prospects of his venture and by observing the
stake an entrepreneur is willing to hold in his proposed project, the investors can separate the
good projects from the bad projects. By following such procedures, the problem of
adverse selection can be partially overcome.

16

However, assuming that the entrepreneur is risk averse, this signaling process can be costly
since the borrower has to invest his own money in order to get funding. Leland and Pyle6
show that if borrowers form a coalition, which they interpret as F.Is, then although the
expected returns per project remain the same, the unit cost of capital decreases with the size
of the coalition borrowers. Thus by looking at banks or FIs in general as information sharing
coalitions, the adverse selection paradigm can generate economies of scale in the borrowinglending relationship.

2.2.3: Ex-Post Informational Asymmetries

Ex-post informational asymmetries (monitoring) generates another imperfection which
justifies the existence of banks. In the previous section, through a theoretical model, we saw
how banks can be interpreted as information sharing coalitions which generate economies of
scale in the borrowing-lending relationship. Now suppose that the entrepreneurs have secured
the loan from investors and as before some information about the project, be it cash flows or
technology, is privately held with the entrepreneur. In such a case monitoring the project
would not only be efficient but also necessary in order to prevent opportunistic behavior of
the borrower during the realization of the project (moral hazard). In fact, Schumpeter (1939)
has essentially assigned such a role to banks.
() the banker must not only know what the transaction is which he is asked to finance and
how it is likely to turn out but he must also know the customer, his business and even his
private habits, and get, by frequently talking things over with him, a clear picture of the
situation
Schumpeter (1939), pg.116, Source: Diamond (1984)

So, to see how banks can be efficient in performing their role as delegated monitors, I
consider alternate methods through which investors can monitor the performance of their
concerned projects.

For a mathematical derivation and detailed discussion refer Leland and Pyle (1977).

17

Proposition 1: the investors monitor the projects themselves.

In such a case each investor or a small group of investors who have financial interest in their
respective projects are entrusted with the task of overseeing the performance of the project
(Figure 2 below). Clearly for such an arrangement to be feasible there have to be few
investors, each with significant capacity. However, even in a case like this where

Figure 2 (Source: Freixas and Rochet, 1997)

Borrower 1

Lender 1

Lender 2

Lender 3
Borrower 2
Lender n

there are few investors, a free riding problem exists. Note that the investors would have to
incur some costs on their part in order to monitor the project. Now, if one of the investor acts
opportunistically and observes others rather than incurring expenditure on monitoring, he
would be able to extract costly information for free. With the result, no investor would be
willing to take on the monitoring responsibility.

18

Proposition 2: banks act as delegated monitors.

Now instead of investors indulging in self monitoring, lets assume they delegate the
monitoring activity to banks. Figure 3 below shows such an arrangement. As soon as banks
come into the picture, things look a lot simpler. The investors delegate the monitoring
function to the bank which oversees the borrowers and in return offers a debt contract or
more accurately a deposit contract to each investor which promises a nominal amount in
exchange for the deposit. And of course, this is not only more efficient but also more secure
since the banks can be liquidated (ignoring the fractional reserve requirement for the time
being) if it is unable to pay its depositors.

Figure 3 (Source: Freixas and Rochet, 1997)

Lender 1

Borrower 1

Bank

Lender 2

Lender 3
Borrower 2
Lender n

19

However, for banks to act as delegated monitors certain conditions must be met. These are:

Scale economies in monitoring should exist. This implies that a typical bank should
finance many projects.

Small capacity of investors as compared to the size of investment projects. This

implies that each project needs the funds of several investors.

Low cost of delegation: the cost of monitoring or controlling the FI itself has to be
less than the surplus gained from exploiting scale economies in monitoring or
controlling investment projects.

Certainly, all the pre conditions listed above for banks to act as delegated monitors seem
realistic. Real world banks are one of the primary sources for commercial finance in an
economy and the fact that they help in channeling consumer savings (which tend to be low)
to productive means is well researched and documented. This, in essence, was the
contribution of Diamond (Diamond 1984) who forwarded the theory of financial
intermediaries as delegated monitors.

2.3: An Extra Perspective on the Theory of Financial Intermediation

Apart from the well established asymmetric information paradigm based theory of banking,
another new line of research has emerged which analyses the theory of banking (and
financial intermediation) through the lens of risk management rather than the traditional
approaches7. Though not much research has been done in this field, the idea itself sounds
interesting and worth considering in this paper. As I have said before, the motive of this
chapter is to reconcile the different theories of financial intermediation in order to build a
solid foundation for our main research question and as such, like with others, only a brief
outline would be included.

In a paper by Bert Scholtens and Dick van Wensveen (2003) the authors have argued about
the validity of informational asymmetries explanation of banks in wake of rapid
7

The traditional approach refers to the informational asymmetries and transaction costs.

20

diversification and technological progress in banking. At the heart of their argument lies the
Value Creation concept originally forwarded by Porter. Acknowledging the pivotal

role

played by traditional theories in helping to build a sound theory on banking, the authors have
taken a different stand on why banks in particular and financial intermediaries in general
exist.

According to Scholtens and Wensveen (SW hereafter) the primary function of a bank is not
to intermediate between savers and investors by producing information on borrowers and
passing it on to savers or to behave as a delegated monitor on behalf of its depositors but to
deal with money and risk. As such, according to SW, even the primary role of channeling
savings into productive use has a hidden perspective to it. While considering different
projects for investment purposes, banks have to undertake large research, legal, and
organizational costs which might prove to be prohibitive for any one single investor. Banks
on the other hand can perform these functions for a group of investors and lower the unit cost
per investor. Also, by evaluating various investment avenues, banks are able to diversify
risks and achieve economies of scale.

Apart from the traditional role of improving resource allocation, banks also encourage
individuals to save more resourcefully by offering products which combine the
characteristics of insurance, depositing and investing. In other words, financial products most
relevant to entrepreneurs like bonds and equities may not be relevant in terms of liquidity,
risk and maturity to savers (like savings and pensions account). Thus, by offering such
maturity matching services banks, in a way, determine the amount of savings in an economy.

By performing this task of asset transformation, SW suggests that banks create value.
According to them information production is essentially a means to the end of such value
creation and risk management (SW 2003).

21

2.3.2: How do Banks Create Value.

So if, banks are to be interpreted as value creators instead of information producer, then the
obvious question is: how do banks create value? The authors note that while banks offer
financial services personified in form of financial instruments, neither the savers nor the
borrowers create value themselves and in many cases, cannot be created by banks
individually. The value creation process is initiated and enhanced by competition between
existing players and new entrants. Considering the fact that the main functions of a bank, as
identified by the contemporary banking theory (see section 2.1), aims at addressing the needs
and preferences of savers and investors through a continuum of financial services; it is only
logical to state that they (banks) have to come up with new solutions to accommodate
changing needs of both the savers and investors. In fact through out the history of the
banking industry, all kinds of payment and credit facilities have been introduced by the
financial services industry and not by individuals themselves.

Coming back to competition and the need for innovation, as soon as an instrument developed
by one bank or an insurance firm gets commoditized and made tradable on open market,
other banks try and develop new, specialized instruments for new specific markets. This in a
way confirms to the Schumpeterian view of creative destruction in that firms have to
constantly innovate to stay ahead in the market.

Of course, there would come a time when traditional markets would saturate but therein lies
the reason for innovation. Financial intermediaries, in order to survive, would continue to
develop and penetrate into niche submarkets. The point here is that when looked at from the
lens of risk management, banks seem to function as value creators by transforming risk and
not as information producers.

22

2.4: Do all theories of financial intermediation contradict each

other?

The current chapter has covered three theories of financial intermediation in brief. While
section 2.2 talked about the transaction costs and information asymmetries explanation
for banks, section 2.3 presented a new line of thought which sees banks as value creators. Do
the three theories contradict each other? And if yes, which one of them is of relevance to us?

In my view, all the three theories of financial intermediation play a significant role in
explaining why banks exist and the conflicting nature, which might emerge, can be attributed
to the fact that theories of financial intermediation have all been developed from an
institutional perspective i.e. where the central focus is on the activities of existing
institutions such as banks and insurance firms rather than from a functional perspective i.e.
based on the services provided by the financial system. So, whilst the transaction costs
explanation would have been suffice in explaining why banks exist during the Italian
renaissance era, when they were primarily seen as money changers and a source of liquidity
and payment services, the 70s researchers saw them as information producers. And today,
the world sees them as value creators.

In an important paper, Merton (1993, see also Merton and Bodie 1995) has argued that while
the functional perspective of a bank (asset transformation and risk management) has
remained stable over the years, there has been a change in the institutional perspective of
banks due to the changing face of the financial services industry itself. With the advent of
information and communication technologies and both broadening and deepening of
financial markets (as a result of deregulation) has led banks and other financial institutions to
pursue diversification strategies in order to survive (Section2.3.2). As a result, whilst some of
the activities banks indulge in can be explained using traditional theories, others cannot be.
For example, while the standard argument for existence of mutual funds lies in diversifying
asset holdings as to get better returns; high trading costs prohibit individuals to do so alone.

23

Mutual funds, on the contrary, can allow individuals to diversify better by pooling their
investments and trading on behalf of them and thus achieving the desired results more
cheaply and more efficiently. Given this explanation, one might be forced to think that if
individual trading costs were lowered considerably, individual interest in mutual funds would
fall. However this behavior has not been observed in real world.

Allen and Santomero (1997) study the share of mutual fund ownership on the New York
Stock Exchange (NYSE) during the 1970s and found that though competition for brokerage
fee and the availability of real time information through channels like Reuters etc. had
considerably reduced transactions cost and informational problems for individual investors,
the share of mutual fund ownership during that period actually rose. In fact intermediation
services have grown in both relevance and size in the face of declining frictions since.
The point here is that while institutions have come and gone, evolved and changed, but the
functional needs persist while packaged differently and delivered in substantially different
ways (Allen and Santomero 1997). So if one looks at why banks exist from a functional
viewpoint, all the theories on banking complement each other. While the transaction cost
explanation can be seen as rationalizing the role of intermediaries in the distribution function
(liquidity and payment services), the information asymmetries explanation can be seen as
both the origination and servicing function (adverse selection, moral hazard and monitoring),
the value creation explanation can be seen as a risk management function where
intermediaries allow risk to be allocated efficiently at minimum cost.

2.5: Some final remarks

The current chapter discusses the theory of financial intermediation while outlining the
important function banks play in an economy. In particular, banks are entrusted with the
responsibility of channeling savings to productive investments and also play an active role in
asset transformation, information processing and risk management.

A well functioning

banking system contributes positively to economic growth and in fact has been well
documented for some time in empirical literature on economic growth.
24

Additionally, given the nature of this industry, its complex linkages with the economy and
issues regarding asymmetry information and risk transformation have all made this industry
vulnerable to potential runs and systematic failure. Also, considering the high degree of inter
dependence between banks through the inter bank money markets, payments systems and
derivatives has meant that the banking system as a whole is even more vulnerable to financial
risks. So if, one day Only Bank fails owing to a credit or liquidity shock, then it would not
only affect its customer namely borrowers and lenders but also other banks which are linked
through the inter bank money market system and other arrangements.

All of the features discussed above and many more have made banking a special industry in a
sense that stability is considered vital for a well functioning financial system and as such
thrown open many important questions like what does competition mean for the banking
market? How best can financial stability be maintained while still ensuring a competitive
behavior? And is competition among banks at odds with the equally important goal of
financial stability? These are some of the issues which would be explored in the next
chapters.

25

Chapter 3

: Competition among banks-good or bad

Introduction:
The current chapter starts from where we left the previous chapter that is to seek answers
pertaining to the appropriate level of competition among banks. To start with, such a debate
may seem unwarranted for. Applying textbook welfare theorems would predict that a
perfectly competitive banking system would maximize efficiency and be welfare enhancing.
Market power, on the other hand, would induce a dead weight loss on the society by allowing
banks to exercise market power and thus charging a higher loan rate to businesses and by
giving out lower deposit rates to retail investors. Such an action would have a dampening
effect on entrepreneurial activities and also cause firms to scale down on their R&D
initiatives. Allowing higher than competitive loan rates would also bring about a preference
shift in borrowers from risk neutral projects to risky projects (since higher risk entails higher
returns), thereby weakening the overall resilience of credit markets. All this would eventually
result in an economy acquiring a slower pace of capital accumulation and therefore diverging
from the more important social goal of achieving highest per capita income for the state.

However, in more recent years, researchers, by studying additional issues regarding bank
competition, have highlighted potential negative aspects of excessive8 competition in the
banking industry. The view supporting market power in banking has mainly originated due to
certain traits the sector commands. In particular:

Banks are more vulnerable to panic runs and risk of failure since their balance sheet
consists of short term deposits on the liability side and long term assets on the asset
side that are difficult to liquidate quickly. In the absence of deposit insurance and
maturity matching products, this puts banks at significant risk.

Here the term excessive competition should be interpreted in literal sense. Recent literature on competition in
banking uses this term frequently and simply presents the current state of the banking industry in certain
markets. For e.g. refer, Vives (2001)

26

Highly leveraged firms have a tendency to undertake more risky activities since its
shareholders are widely dispersed and so its activities difficult to monitor. Banks tend
to fall in this category. Large shares of debt holders in banks are depositors who have
small claims and as such lack the necessary skills and time to monitor the banks
activities and consequently the potential risks.

These and other characteristics (section 2.1) of banks have made them special in a sense that
stability, achieved through market power, is conceived necessary for a flourishing banking
system since banks with higher profits would be, in principle, better placed to absorb any
shock to the liquidity system.

Also, as established in the second chapter, banks primarily exist due to indivisibilities in the
financial system and are seen as information producers and risk transformers. As such, this
makes banks prone to market failure. In particular, I discuss market failure arising due to
asymmetric information.

Asymmetric information and market failure: banks are prone to informational

asymmetries on both the liabilities side and the asset side. On the liability side, asymmetric
information arises since depositors do not possess the requisite information on the true value
of their respective banks loan portfolio or in other words the viability of loan hand outs due
to the obvious reasons of lack of time and experience in gauging the default probability of
loans. In addition, banks are required to maintain a fractional reserve system (minimum
liquid asset holdings) to act as a buffer against mass withdrawal. However, if this fractional
reserve holding is only partially backed by reserves, then a mass withdrawal, triggered by
release of bad information about the banks assets can lead to illiquidity and even default9.
Such a process is helped by the fact that a depositors outlook on safety of his deposits
depends on their place in line at the time of withdrawals or the so called first come first
serve principle. So if depositors panic about the safety of their deposits, they may try and
9

Such a constraint is not only observed in the banking system, but is common throughout the financial system.
As such, stock markets quite often experience such so called announcement effect where selling by few
players on the market triggers the stop loss and the index plunges.

27

withdraw funds before anyone else does and in due course causing a panic run on an
otherwise sound bank and thus forcing bankruptcy.

On the asset side, as discussed in the second chapter, there exists information asymmetries
between the banks and its loan applicants. In particular, banks are not fully informed about
the risk-return characteristic of the project which may give rise to adverse selection, moral
hazard and ex-post verification problems (refer section 2.2.2). All three problems hinder
borrowers to raise the necessary capital from lenders, even where the projects project a
positive net present value. (Canoy et.al. 2001).

Finally, another peculiar characteristic of banks being the high degree of co-operation among
them has made the industry even more prone to systematic risks and failure. In fact, banks in
an economy are inter- connected so strongly through various arrangements that one refers to
them as a banking system and not just as n number of banks functioning independently.

With the result, that even if a single bank fails in an economy

(due to a credit or a liquidity shock), it can infect the whole
banking system. Although research on the effects of
contagion on financial stability is scarce, Allen and Gale
(2000b) provide some important results. The authors
consider a regional banking system connected through a
network of inter-bank deposit services and how a liquidity
shock to one regional bank can infect the whole banking
system through this network. Since no banking market is
connected to the same degree, nor is the level of regional
economic integration anywhere in the world, the authors
consider three types of inter-bank money market system as

Figure 4:Inter-bank linkages

Source: Northcott (2004)

shown in figure 4. Of the three types discussed, a complete

Figure
(Taken
from
market is thought of as one where each bank has links to every other
bank4in the
region.
An
Northcott, 2004)

incomplete structure is one where banks have links with their adjacent banks only. The
Inter bank linkages

incomplete and disconnected structure is where regional banks do not have any relation on

28

the inter-bank money market. In such a setup, the authors demonstrate that while a complete
structure is most insulated to a contagion event due to a large number of banks sharing the
shock and so possibly lowering the cost of the event, incomplete market structure is most
susceptible to contagion since the cost is borne by a few banks. The problem is aggravated by
the fact that since fewer number of banks borne the shock, the likelihood of any one bank
absorbing the shock is low and so the spillover effect continues to act and spread contagion
across the region. Within the incomplete market structure, an incomplete and highly
connected one poses as the most susceptible to contagion.

In light of such arguments, the debate on the appropriate level of competition has essentially
turned into a trade off. While the traditional Industrial Organization (IO) theory deems
perfect competition ideal for banking, as it maximizes allocative efficiency (ensuring the
greatest amount of credit at lowest prices), research in recent years and the discussion above
have highlighted how a fragile banking system can be exposed to financial instability.
Indeed, as discussed in the first chapter, financial de-regulation in the U.S during the 1970s
was thought to be one of the major factors behind the banking failure during the 1980s. Such
incidents were not only restricted to the U.S but have started to emerge all over the world. In
a study by Hoggarth and Sapporta (2001, refer chapter.1), the authors found the costs of
banking crises alone throughout the world to be 4.5% of world G.D.P.

Then to model such a trade off is not trivial and requires us to work out which kind of a
market structure, if any, would promote both stability and economic efficiency (allocative
and productive efficiency). The following sub-sections would essentially contribute to such
a debate, while analyzing the different competition structures in the context of banking.

3.1: The Debate Started- Competition and Banking

From the point of view of social welfare, economists favor competition since under it firms
are encouraged to utilize scarce resources in an efficient manner leading to a higher
consumer surplus than under firms operating with market power.

29

On the extreme lies Perfect competition wherein forces of demand and supply work freely to
determine the allocation of resources among different goods and distribution of income
among other factors. In this market structure, the degree of competition is so high that no
individual firm can influence the price of the product. The perfectness comes about in the
market under certain conditions such as:

Economies of Scale are small relative to the size of the market. This means that
average costs will rise rapidly if a firm increases output beyond a relatively small
amount.

Output is homogeneous. That is, consumers cannot distinguish between products

produced by different firms.

Information is perfect. All firms are fully informed about their production
possibilities and consumers are fully aware of their alternatives.

There are no entry or exist barriers. This means that the number of firms in the
industry adjusts over time so that all firms earn zero economic profits or competitive
rate of return.

In the context of banking, such a market structure would imply that there are a large
number of small profit maximizing banks in a market, each offering a set of
homogeneous deposit and lending contract at market determined prices. Such an
arrangement would lead to greatest amount of credit being offered at lowest prices and
would thus maximize welfare.

However, due to market imperfections such as imperfect information, entry and exit
barriers and product differentiation, a perfectly competitive world mainly resides in
textbooks. As such, no industry conforms to these assumptions and certainly not banking.
Remember that, our discussion on why financial intermediaries exist at the first place was
derived from existence of large economies of scale and scope and asymmetric

30

information. Also to the extent that there are considerable amounts of sunk costs10 in this
sector, the assumption that no entry barriers exist is also misplaced.

However, to keep the debate alive on the appropriate level of competition in the banking
sector, we can certainly analyze the effects of excessive competition in this sector.
Besanko and Thakor (1992) examine the market for loans and deposits in a theoretical
context where banks differentiate themselves from competitors11 spatially. The model
itself works under the assumption of free flowing entry in that the market for loans and
deposits is fiercely competitive. The model also assumes that banks have very little
market power (arising out of locational advantage), with the result that no single bank can
influence market prices12.

In such a setup, the authors conclude that loan rates decrease and deposit rates increase as
more banks enter the market. The result sound encouraging. Lower lending rates and
higher deposit rates would stimulate higher entrepreneurial activity in the economy and
would encourage firms to invest more in their R&D operations. This would not only
accelerate the pace of technological innovation and productivity growth, but would also
result in a faster process of capital accumulation and therefore highest levels of income
per capita.

However, as with every model, the outcome achieved here is been made possible due to
certain assumptions which when relaxed may not present the ideal situation. In particular,
the authors assume that borrowers would eventually obtain credit from some bank.
Realism warrants us to assume that generally a market place would consist of two types
of borrowers: Good borrowers, who repay on average and Bad borrowers who are
not able or do not intend to pay their loans. Also assuming that banks would like to fund
only good borrowers, Shaffer (1998) demonstrates that in a market with large number

10

For example, traditional banking is very much based on physical presence so that branch network has to be
established. Even for internet banking, banks have to invest a lot in reputation.
11
The banks differentiate themselves spatially. This approach is similar to Salop (1979) and Hotelling (1929)
12
An increase in the number n of banks in this model reduces the extent of bank differentiation.

31

of banks, the chances that any given borrower would not get a loan (including the bad
ones) is very low.
The intuitive idea behind such a result is that the least risky or good borrower will tend
to be approved by the first bank approached. If credit screening is imperfectly correlated
across banks and if each lender is unaware of whether an applicant has been rejected by
other banks, riskier applicants would shop around until some bank is willing to extend
a loan. In such a world, Shaffer shows that the average creditworthiness of the pool of
applicants is then systematically degraded as a function of the number of banks. With the
result, the expected loan losses also become an increasing function of the number of
banks. Of course, one can argue that access to credit bureaus and other tools of
information aggregation can mitigate such adverse selection effects by making banks
aware of a borrowers prior application to other banks. To this, Nakamura and Shaffer
(1993) suggest that even when a banks awareness of prior applications is coupled with
the additional knowledge of prior rejections, the resulting aggregation of information may
not always suffice to offset the adverse selection completely.

Besides assuming that the borrowers eventually manages to secure a loan contract from
some bank, Besanko and Thakor also assume that when a borrowers project is
unsuccessful, the banks collect nothing. To the extent that expected loan losses become
an increasing function of the number of banks, no collateral requirements or no
punishment for non payment of loans can increasingly attract bad borrowers, thus
affecting a banks net worth (banks equity).
A shock to a banks net worth can affect the amount of credit it supplies since the
quantity of credit available not only depends on market structure but also on factors such
as net worth. Banks finance lending with liabilities (such as deposits) and equity and as
such are subject to capital requirements that set a minimum allowable capital-to-asset
ratio, which takes into account the riskiness of assets. Therefore extending loans to risky

32

customers can lead to lowering of a banks net worth which can lead to a decrease in
lending and consequently lower economic growth13.
According to Northcott (2004), if a banks capital-to-asset ratio falls below a set
minimum level, it is left with two options. Firstly, the bank can restore its capital by
either issuing new capital or by decreasing dividend pay outs. While the former would
prove costly, the latter would adversely affect its share prices and thus its net worth. The
second choice is to decrease its assets; that is, to decrease lending.
Therefore, by lending to bad borrowers and then having no solution to recover would
provide a negative shock to the banks net worth resulting in lower lending even in a
competitive market structure.

Another feature of the Besanko and Thakor model is that the market for loans and
deposits is fiercely competitive. Intuitively, this means that no single bank is big enough
and thus has low earnings. Given the fact that an excessively competitive market
structure in banking can result in a poor loan portfolio build up and negatively affect a
banks net worth, what implication does such a situation have on financial stability? As
weve discussed above, banks are connected through a series of arrangements, enabling
them to carry out payment and other services efficiently and how this interconnectedness
can result in a systematic failure. Again, given that in the Besanko and Thakor world the
banks are small and bad assets would form a significant part for the aggregate industry, a
liquidity shock to one bank would spread faster to all the other banks simply because no
one bank has the capacity to absorb the shock, thus degrading the overall resilience of the
financial system. In fact such market structure confirms to the incomplete and highly
connected market structure proposed by Allen and Gale (2000b) which is highly prone
to contagion.

13

Literature of finance-growth nexus describes such a lending channel where lowering of a banks net worth
affects its credit supply. E.g. Bernanke, Gertler and Gilchirst, 1996

33

The discussion so far suggests that the efficiency stability trade off is not as straight
forward as the traditional IO theory suggests. Although near perfect competition
conditions would reduce lending rates and increase deposit rates in the short run, the
inherent market imperfection in this sector would introduce instability in the long run and
defeat the whole purpose of competition itself.

In light of such arguments, would it be safe then to abandon competition in favor of

stability. Put differently, would a monopoly banking system be able to deliver stability
and at the same time ensure allocative efficiency. Alternatively can an oligopolistic
banking system ensure such goals?

Another important aspect not discussed till now is

the role of regulation in banking. The banking industry is among one of the most highly
regulated industry world over and as such warrants a discussion on how useful it is in
contributing to the efficiency- stability tradeoff. The next sub-section discusses these
issues.

3.2: Stability vs. Efficiency Part II- Market power and Banking
Market power can be defined as the ability of a firm to price above marginal cost without
losing all its customers to competitors. At the extreme lies monopoly, wherein there
exists a single seller and as such does not face any competitor from any close substitute.
Since a monopolist faces a downward sloping demand curve, the inefficiency in
monopoly pricing stems from the fact that a monopolist restricts output in order to earn
monopoly revenues. And by doing so, a monopolist inflicts a dead weight loss on the
society.

A second effect of monopoly power is the transfer of surplus from consumers to the firm
as profits. Under competitive pricing, both monopoly profits and the dead weight loss
would have gone to consumers as surplus. In order to realize a larger share of the gains in
trade, the monopolist raises price above marginal cost. However, this comes at a cost to
society in the form of lost surplus, since some consumers respond to the price rise by
reducing their quantity demanded.
34

Applying the same arguments to the banking industry, one can argue that banks with
market power would also restrict output (increase lending rates) and decrease deposit
rates in order to earn monopoly revenues. However this does not happen in practice.
Stiglitz and Weiss (1981), through a theoretical model, demonstrate that banks essentially
ration credit instead of increasing lending rates in concentrated markets14 in response to
excessive demand for loanable funds.

The rationale behind why banks behave in this way is in part due to the winners curse
argument forwarded by Shaffer (1998). In particular, banks making loans are only
concerned about the interest rate they receive on the loan and the riskiness of the loan.
However, the interest rate a bank charges may itself affect the riskiness of the pool of
loans. This cause and effect relationship is again derived from the imperfect information
(adverse selection and the incentive effect) which is present in the loan market.

Remember from our discussion on adverse selection above that a market place would
generally consist of two types of borrowers: good borrowers, who repay their loan and
bad borrowers, who do not repay their loans. Also, since the expected return to a bank
depends on the probability of repayment, a bank would obviously be interested in
gauging the repayment capacity of the borrowers so that it only funds the good
borrowers. As such, identifying a good borrower ex-ante from a pool of borrowers is a
difficult task and requires the banks to implement a variety of screening devices. In their
model, Stiglitz and Weiss assume interest rates, which individuals pay, to act as such a
screening device: those who are willing to pay high interest rates may on average, be
worse risks; they are willing to borrow at high interest rates because they perceive their
probability of repaying the loan to be low. As the interest rate rises, the average riskiness
of those who borrow increases, possibly lowering a banks profit.

14

Although Stiglitz and Weiss do not explicitly model competition among banks, they work on the assumption
that banks are price setters on the credit market and quantity setters on the deposit market.

35

Another peculiar problem which the authors point out a bank faces while deciding on the
interest rate is the change in the borrowers behavior towards risk taking in relation to
interest rate changes. To the extent that information is perfect and costless, banks, in
order to maximize returns, would simply stipulate precisely all the actions a borrower can
undertake. However due to asymmetric information, banks are not able to directly control
all the actions of the borrower. To circumvent this problem, banks would formulate the
terms of the loan contract in a manner designed to induce the borrower to take actions
which are in the interest of the bank, as well as to attract low risk borrowers.

A common thread running through both the arguments above is that higher interest rates
imply higher risk taking behavior. The fundamental premise behind such thought is that
in presence of other sources of finance such as secondary markets, an interest rate hike
(beyond a certain point) in response to excessive demand for loanable funds would not
only drive away good borrowers15 and at the same time induce risky borrowers to come
forward but would also encourage risk averse borrowers to shift to risky projects16.

With the result, the market for loanable funds faces a backward bending supply curve in
that the expected return by the bank may increase less rapidly than the interest rate; and
beyond a point may actually decrease. Consequently, it may not be in the interest of the
bank to raise interest rates in response to excessive demand for loanable funds; instead
banks can ration credit and thus increase allocative efficiency.

Another way through which banks can increase allocative efficiency of capital is by
engaging in relationship lending. Banks engage in both relationship and transactional
lending. Relationship lending refers to the development of sector-specific expertise and
long term financing arrangements with firms. Such an agreement is most beneficial to
firms with no past credit history, collateral or credit constrained firms.

15
16

Transactional

Assuming good borrowers prefer cheaper financing

Since, if successful, risky projects would yield higher returns.

36

lending (like commercial papers, equity and bond markets), on the other hand, involves
arms-length lending based on readily observable information about the firm17.

Acknowledging the important role of small firms in an economy, Petersen and Rajan
(1995) argue that in an excessively competitive market structure, banks would not be
willing to enter into relationship lending and thus constraint finance for young firms.
When a firm is young or distressed, the potential for future cash flows may be high, while
the current state of cash flows is low. When evaluating a project, creditors (banks) should
not only consider the current cash flows but also the future stream of profits it may
generate.

However, as we now know, banks also face a pool of risky borrowers and young firms
are particularly risky due to the element of uncertainty attached to their existence. In such
a scenario, banks, in a competitive credit market would be forced to increase lending
rates till the uncertainty is resolved (the young firm establishes herself). To the extent that
banks charge a higher rate of interest, it would also invite a riskier pool of applicants
(adverse selection) and also bring about a preference shift from risk averse to risk taking
behavior. To circumvent this adverse selection problem, banks would be induced to
ration credit. All this would eventually result in limiting finance opportunities for young
firms.

The thought that relationships and competition are incompatible is not only restricted to
the credit market but echoes in other sub-disciplines of economics as well. For instance,
labor economist claim that a firm is more reluctant to invest in training workers in a
competitive labor market unless they post a bond, since workers can threaten to quit or
demand a competitive salary once they have been trained. Similarly, a competitive credit
market would be unwilling to enter into relationship lending with young firms for if the
young firm in question is successful and is established in the market, she can be lured
away by other banks at better deals, leaving the current bank to be at the receiving end.

17

For example, funds raised by issuing debt or equity.

37

In fact Hoshi, Kashyap and Scharfstein (1990) documented that high quality Japanese
firm moved away from their banks when the domestic bond markets were liberalized.

A bank with market power, on the other hand, can share in the future surpluses generated
by the firm through the future rents she is able to extract. The banks can backload interest
payments over time subsidizing the firm when young or distressed and extracting rents
later. Consequently, a bank in a concentrated market structure may be more willing to
engage in relationship lending than her counterpart in a competitive structure. Petersen
and Rajan also demonstrated that the surplus extracted in the future does not affect the
firms choice between projects (as in risk averse or risky project), but the lower initial
rate give the firm an incentive to take safe projects initially when applying for loan and
thus increasing allocative efficiency.

Of the two theoretical models outlined above, while the Petersen and Rajan model
explicitly assumes banks to have a certain degree of market power in order to engage in
any kind of relationship lending, the Stiglitz and Weiss model implicitly assumes banks
to have market power. I say implicit because the model itself does not take into account
competition among banks, however for a bank to ration credit, it ought to have some
degree market power. This is so because in an excessively competitive market for loans
and deposits, banks would be constrained to break even on a period by period basis and
would have to passively sit back and follow the free market mechanics.

Then, for a moment, if we do assume that market power actually translates into allocative
efficiency and at the same time ensure stability, can we generalize these results? At this
point, I wish to remind the readers that even though the results point towards limiting
competition in the banking industry, the models themselves have been built on certain
assumptions. While these assumptions stand true or not is an empirical issue and as such
would be discussed in the next chapter, for the time being we continue investigating
additional factors which lead us to a concentrated banking industry.

38

3.2.1: Market Power and Banking- The Debate Continued.

Banking markets have a natural tendency to become concentrated because of the intrinsic
indivisibilities in the financial system (refer chapter 2). Put differently, firm size matters
in banking. Even if one believes that concentration and large firm size can be bad for
competition since they maintain and make use of market power to the disadvantage of
consumers, concentrating on consumer welfare alone would amount to a partial analysis
of the problem. Instead, the relevant question for economists to analyze should include
the bigger picture and take into account producers benefit as well. As we now know that
banking markets suffer from inherent indivisibilities (scale economies and asymmetric
information), which also translates into increasing returns to scale, reducing market
power would also mean lower profits for banks. However, in order to cover up financially
to overcome such indivisibilities, banks need to exercise some market power or in other
words need to work on higher than competitive returns. Thus, the degree of concentration
in banking markets alone is not a sufficient indicator of how competitive the market is. In
fact, recent literature on bank competition and industrial organization alike has
recognized this fact and has proposed to focus on issues such as contestability, instead of
inferring results based on the degree of concentration alone. Following such footsteps, I
further elaborate on factors which make concentration come naturally to the banking
markets and also why market power might not be harmful.

A critical factor in any market which governs the competitiveness of a sector is thought
to be barriers to entry and exit. One of the reasons why contestability is thought to be best
from a social viewpoint is because in the absence of any entry barriers, firms can come in
quickly and take away any excess profits which a monopolist might be earning (in other
words, the hit and run phenomenon). However as we shall see, in our case, whilst some
entry barriers come physically to this sector, others have been created just to promote
social welfare.

39

3.2.2: Entry Barriers in Banking

Barrier to entry in any market is defined by the degree of sunk cost investments in that
particular market. Entry into the financial sector requires substantial costs which tend to
be sunk to a high degree. For instance, retail banking is very much based on the concept
of branch networking, which requires investments sunk to a high degree. Even where,
banks operate electronically (e-banks), investment in reputation and trust building
requires substantial investment, which might turn out to be sunk. As is well know from
the literature on strategic entry deterrence, sunk cost technologies put new entrants on a
cost disadvantage compared to incumbent firms and so might deter free entry into this
sector. Particularly investments in building up customer goodwill and reputation such as
advertising or developing client network may be irreversible upon exit.

Another type of entry barrier, especially in retail banking may exist because of demand
side peculiarities. Universal banks which offer one stop shop experience compared to
other more specialized institutions may give them switching cost advantage over other
single product banks, giving them the necessary scale through diversification. Although,
this does not act as an entry barrier, the fact that switching banks is harder due to account
information and other personal data make it more complex and difficult for customers to
switch banks. Moreover, differentiation of financial products and services has made
direct price and service comparison even more difficult for customers.

Entry barriers also restrict exit. Once a bank has entered the market, sunk investments
make it unattractive to exit when profit opportunities are vanishing because assets can
only be sold off with a loss. In case of banks, assets refer to loan it has made out to
entrepreneurs!

Another significant entry barrier in the banking industry is regulation. Banks are one of
the most highly regulated industries in the world due to their fragile nature. Public
regulation, in general, is justified by market failures that can come from (a) presence of
40

market power (b) the presence of externalities or (c) asymmetric information between
buyers and sellers. However, the official justification for regulation in the banking
industry comes from the necessity of providing a safety net for banks to protect
depositors from the risk of failure of their banks (financial contagion, section 3).

For such reasons, entry into the financial system, particularly in banking and insurance is
regulated in almost all countries. For example, banks have to be charted by a regulating
authority is a common norm now in most countries around the world. Additionally, in
some countries, certain type of banks like development banks or export-import banks get
preferential treatment compared to others, giving them certain cost advantages. Host
country regulators may also act demandingly when allowing foreign banks to operate in
their country, like requiring them to setup headquarters or branches in that country

Yet another barrier to entry thought to exist in the banking sector is adverse selection.
Dell Ariccia et.al. (1999)

develop a model similar in spirit to the one developed by

Shaffer to demonstrate that new entrants in the financial system would face adverse
selection as a barrier to entry. The authors characterize the equilibrium under Bertrand
competition and demonstrate that an equilibrium where the third bank enters does not
exist.

In order to get this result, the authors assume that banks face uncertainty about the
creditworthiness of the borrowers ex-ante. If they obtain information about borrowers
after lending to them, they are able to reject riskier borrowers when re-financing.
Potential entrant banks will face an adverse selection problem in that new entrants will be
unable to distinguish new borrowers from old ones who have been rejected by their
previous bank. Put differently, using Bains terminology, a third potential bank faces
entry blockaded and is unable to penetrate the market without incurring losses. The
reason is that a third potential bank considering entry faces a significantly different pool
of borrowers than the two incumbents. Also, given that banks compete in Bertrand
fashion, incumbent banks profits from its new customers are already zero and so the

41

potential pay-off from entry by a third bank is unambiguously worse than the two
incumbents.

However, one can obviously question these results on the basis that the authors do not
take into account the timing of entry and of competition. if we were to accept that entry
may be a decision that takes place over a long period and is necessarily a decision made
prior to competition, even then adverse selection posses as an entry barrier. This is so,
because as bank 3 enters she not only tries to lure away old customers of the incumbent
banks, she also faces the rejected pool of applicants from the established players
(incumbent banks). To the extent that incumbent banks are making zero profits on new
customers, the entrant not only makes the same on this segment, but also has to deal with
the rejected pool of applicants. Hence bank 3 must make negative profits overall, if it
ever enters. Put simply, the entrant bank face higher cost of operation during this entry
period than incumbent banks do, which leads to the deterred entry result.
Thus banks which have been in the market long enough would have a certain information
advantage over these new entrants by virtue of their established relationships with
borrowers seeking credit. This can put new entrants in a worse position relative to the
incumbent and may therefore lead to diminished or deterred entry.

In fact the results obtained above are not in isolation. A large literature has recognized
that, in a variety of settings, perfect competition cannot be attained in presence of
asymmetric information. For example, Schmalensee (1982) analyzes the case where
buyers are uncertain about product quality of each particular producer and can resolve
that uncertainty only by buying and trying the product. He shows that in such a setting an
incumbent firm may be immunized from competition by potential entrants, by virtue of
the superior information consumers have about the incumbents product. One of the main
points of this article is to explore a new channel through which imperfect information
undermines competition.

In the context of banking, an article similar in spirit is done by Broecker (1990), which
analyzes a competitive credit market where banks have the ability to perform binary
42

creditworthiness tests on applicant firms and offer credit conditional on the realization of
this test. Broecker finds that as long as this test is imperfect and independent across banks
performing it18, increasing the number of banks can have adverse effects on the
equilibrium interest rates obtained. In his model, this effect arises because with more
banks performing independent tests, the average creditworthiness of firms that pass at
least one test is decreasing in the number of banks. whenever a firm accepts the highest
possible interest rate offer, it must have been rejected by all other banks and therefore
represents a very bad risk on average, consistent with the winners curse argument and the
credit rationing theory.

Consequently, barriers to entry and the respective indivisibilities in the banking system
warrant us to believe that not only does concentration come naturally to this sector but is
also necessary and beneficial. Then the appropriate question no longer remains whether
market power is good or evil for banks, but rather how much market power is needed to
achieve the desired goals of stability and efficiency. In such a scenario, the debate
essentially acquires a two dimensional face with respect to market power. That is, either
the banking sector can turn towards a monopolist market structure with just one bank
operating or the sector can reflect a oligopolistic market structure with a few firms
operating simultaneously.

3.3.3: Monopoly and Banking

As far as the issue of monopoly in banking is concerned, though a monopolist bank may
perform well on the stability front in that would be able to absorb any liquidity or credit
shock in the system, it would not be able to achieve the desired efficiency levels.
Remember from our discussion so far that in order to achieve high allocative efficiency,
banks screen and monitor projects which they have funded. A monopolist bank, realizing
her position, would screen excessively19, resulting in lower credit supply in the market.

18

For example, each bank would have its own credit scoring model.
Since monopolies charge a higher rate of interest, they would screen excessively in order to mitigate moral
hazard effects, For example, see Guzman (2000).
19

43

This would have a negative impact on entrepreneurship and slow down firms investment
in research and development leading to a slower pace of technological innovation and
productivity growth20.
Higher lending rates would also slow down firms investment in research and
development, thus slowing down the pace of technological innovation and productivity
growth. Lower supply of loanable funds coupled with higher lending rates, should also be
reflected in a slower process of capital convergence to the highest levels of income per
capita. Also, though not explicitly modeled in the works of Petersen and Rajan, a
monopoly bank would intuitively not engage as much in relationship lending as would
banks in a concentrated banking system21.

Additionally, a monopoly banking system would not be able to achieve as much

productive efficiency as a comparatively less concentrated banking system would. The
idea of a single bank, like other monopolies, would introduce an element of Xinefficiency or organizational slack in the firm in the sense that their incentive to innovate
would be lower than for firms exposed to competition.

Finally, a monopolist bank would also introduce agency problems such as the principle
agent problem and moral hazard in the system. Given the fact that shareholders and
depositors of a bank are displaced and small, a monopolist bank manager would not
strive hard enough to ensure maximum returns are achieved from investments leading to
a loss to shareholders and inferior returns to depositors. Also, the managers may turn over
ambitious pursuing goals for their own interest which might diverge from the interest of
shareholders22.

20

A monopoly bank would be hesitant in forwarding loans for research and development and new projects since
there is always a good amount of risk involved in it.
21
Young firms entail high degree of risks. As such, a monopoly bank would be hesitant to take on such risks on
a large scale.
22
Managers may strategically invest in firm expansion, since growth increases their power by increasing
resources under their control. So for example, to increase business, bank managers may lend money to
entrepreneurs whose probability to fail is high.

44

Therefore a monopolist banking system would only contribute to one part of the debate
that is to ensure stability in the financial system and to the extent that agency problems
may crop up, even stability hinges on strict corporate governance norms and regular
monitoring. Moreover, considering the fact that regulation plays an important role in
banking, no regulatory policy would favor one aspect over the other and it is because of
this that the debate was sparked off at the first place.

Note that, my intention throughout the paper has not been to reject competition in the
banking sector or to promote monopoly. Admittedly, competition is important for the
banking industry, in principle, for it not only promotes both allocative and productive
efficiency but also helps highlight private information, albeit imperfectly, in the credit
market (Cao and Shi 2000). However in light of liberalization and de-regulation, the
financial sector has witnesses increasing amounts of competition (both structurally and
behaviorally) which has made the whole system more fragile for reasons outlined above.
Realizing the grave dangers instability poses for the economy as a whole, there has been
a rejuvenated interest in the research community at large to debate the perils of excessive
competition. Note that throughout this chapter I have mentioned the word excessive
competition in the banking industry. However banks can have market power and still
function in a highly competitive setup achieving both stability and efficiency. Such is
an oligopolistic market structure.

3.3: Stability vs. Efficiency Part III-Oligopoly and Banking

An oligopolistic market structure is said to prevail when there are a few firms or sellers
in the market producing or selling a product. Since an oligopolistic market structure
contains only a few firms, each seller is usually able to influence the terms of trade in the
market and is aware of his own market power, as well as that of others. This high degree
of interdependence occurs because when the number of competitors is few, any change in
prices, output or product etc. by one firm will have a direct effect on the fortune of its
rivals. It is, therefore, clear that the oligopolistic firm must consider not only the market
demand curve for the industrys product but also the reactions of the others firms in the
45

industry to any action or decision it may take: Ford does not and cannot ignore Honda
when making decisions.

Additionally, the strategic inter dependence factor, unlike monopoly or perfect

competition, leads to many models of oligopoly: the various oligopoly models differ in
the type of actions firms may use such as set prices a la Bertrand model or set outputs a
la Cournot-Nash model. Lastly, assuming firms to be profit maximizing, the equilibrium
price in an oligopoly market lies between that of competition and monopoly. Due to the
economic interdependence in an oligopolistic market structure, each firm maximizes its
profits given its beliefs about how other firms behave: Each firms expected profits are
maximized when its expected marginal revenue equals its marginal cost.

Intuitively, the characteristics of an oligopolistic structure seem particularly appealing

with regards to the banking system. As far as the issue of stability goes, an oligopolistic
structure would stimulate banks to behave more prudently. The idea that each firm has to
take into account actions of other firms in the industry would to a certain extent, prevent
firms from excessive risk taking: if banks are aware of this interdependence and how
actions of other banks can affect their business, then they would in a way make sure that
they themselves (banks) behave in a prudent manner. In fact an oligopolistic banking
structure with not too many and not too few banks confirms to the highly connected and
complete market structure which is least prone to financial contagion (section 3).

Also, to the extent that allocative and productive efficiency is important for the banking
industry, whether an oligopolistic banking sector achieves these goals or not is an
empirical concern but theoretically it sounds better than the other two competition
extremes (monopoly and perfect competition). Again, one of the ways through which
banks try and mitigate information asymmetry is by screening applicants. However, this
screening process is costly and given that competing banks can monitor the results of the
screening process (by simply observing if the applicant was offered a loan), there exists a
free-rider problem which decreases a banks incentive to screen.23 Cetorelli and Peretto
23

Borrowers may shop around till they find a good deal

46

(2000) analyze a banks incentive to screen in a general equilibrium model of capital

accumulation. The authors show that in order to overcome the free rider problem, banks
tend to screen only a proportion of borrowers and so lend to both risky and safe
borrowers. In such a setup, the number of banks operating in a market has an opposite
effect on the quantity of credit supplied. As the number of banks decrease, the incentive
to screen borrowers increases and so too does the proportion of safe borrowers. On the
other hand, an increase in the number of banks reduces a banks incentive to screen and so
the probability that a risky borrower gets the loan increases. This presents another
important trade-off for regulators and policy makers. Although an increase in the number
of banks i.e. more competition would increase credit supply in the economy, it would
also increase the proportion of non performing assets in the economy and thus weaken
the overall health of the financial system. Cetorelli and Peretto show that given the
screening constraint, an oligopolistic market structure best promotes economic growth by
putting the economy of a faster path of capital accumulation.

3.4: Stability vs. Efficiency Part IV- Debate Concluded

So, as we saw, the debate on competition in the banking sector is not as straightforward
as traditional IO theory suggests. In particular, contrary to popular beliefs, market power
in banking may not bring with it all the welfare losses textbooks predict when it comes to
the banking sector. In fact for a bank to behave in a prudent manner, it ought to have a
certain degree of market power. Having said this, even monopoly is not suitable for
banking industry. The point here is that instead of looking at the whole issue from a
market power perspective that is looking to enhance market power in banking; the issue
should be analyzed from the perspective of competition that is to limit competition. In
fact, going by the literature on contestability, a more concentrated banking system,
under certain conditions such as fewer regulatory restrictions and presence of foreign
banks, can still be highly competitive and at the same time maintain stability24.
24

Since banks are characterized by double Bertrand equilibrium i.e. they first set quantity on the deposit market
and then set prices (interest rates) on the credit market, as such, even two banks operating can achieve a
competitive outcome.

47

The current chapter, building on some of the best known theoretical models on this
subject, has outlined the cons of excessive competition among banks and why market
power is more of a necessity than luxury. However, all the models outlined have been
state contingency limited period models. Although the assumptions here are consistent
with real world phenomenon, one should remember that an economy always lives in a
dynamic environment facing stochastic shocks and as such one cannot totally rely on
static models.

For such reasons, a quantitative assessment of these results is necessary in order to

contribute knowledgably. The next chapter would look at the empirical evidence on this
subject, summarizing the theories behind such quantitative debates and the results
achieved.

48

Chapter 4: Empirical

evidence

Introduction:
This chapter examines the empirical evidence on bank market structure and its implication on
credit market efficiency. Consistent with the theoretical models analyzed in the previous
chapter, the idea that market power in banking might not be detrimental for allocative
efficiency is gaining ground at the empirical level. However, acceptance to such an idea is
only recent, prior to which a considerable number of studies argued empirically against the
negative impact of market power on efficiency (see for e.g. Alhadeff 1954, Fischer 1968).

The change in outlook has primarily been motivated for two reasons. Firstly, the general
acceptance to market imperfections present in the banking market and the important issue of
stability has caused the research community to take a new look on the whole issue of
competition among banks. Secondly, given the special status of banks in light of such
imperfections, the basis of empirical literature which argued against market power (the
Structure Conduct Performance Paradigm) has given way to more modern theories of
analysis such as Contestable Markets Hypothesis and the Efficiency Structure
Hypothesis. Both the hypothesis, instead of focusing on the number of firms active in a
market, concentrate on issues which highlight ease of entry, openness to foreign players,
regulatory reforms and see market power as a reward for showing higher efficiency in

49

operations. With the result, the notion that higher degree of concentration always distorts
allocative efficiency is no longer fully acceptable.

This chapter seeks shed light on the theories behind the empirical studies and the evidence
itself in order to compliment results stated in the previous chapter. The chapter is organized
as follows: Section 4.1 considers empirical evidence on how might market power be
beneficial for both stability and allocative efficiency. Section 4.2 looks at the structural
approaches to competition (SCP and ES hypothesis). Section 4.3 outlines the non-structural
approach to competition (Panzar-Rosse model). Section 4.4 presents some final thoughts.

4.1: Stability vs. Efficiency- empirical evidence

Our discussion on the stability - efficiency debate in the third chapter centered around the
theme that credit market efficiency does not only rest on market structure, but also on the
extent to which credit was forwarded to good borrowers. Another feature of the debate which
came to light was that stability is essential in maintaining a flourishing financial system in a
sense that a fragile banking system would possibly systematically degrade the overall
resilience of banks, leading to a less efficient allocation of credit.

Empirically also, there seems to be considerable support for such thoughts. Beck, DemirgucKunt and Levine (2003), construct a logit probability model using data on 70 countries from
1980-1997. In order to deduce meaningful and robust results on the impact of banking
market structure on financial crises, the authors control for a number of factors such as the
kind of deposit insurance regimes, capital regulations, regulatory environment and the
ownership structure of the industry, i.e. percentage of foreign ownership versus domestic
ownership.

The authors also consider certain macroeconomic variables like inflation,

economic growth and the overall institutional environment.

In such a setup, Beck, Demirguc-Kunt and Levine demonstrate that crises are less likely in
economies with (a) more concentrated banking systems, (b) better contestable environment
and (c) national policies which encourage competition. The results achieved here are in fact
50

consistent with the view that concentrated banking systems tend to behave more prudently
and that they are easier, for regulators, to monitor than banks in less concentrated banking
systems.

Whilst, there are many reasons why a concentrated banking system might behave more
prudently, the key to all the arguments lies in moderation of risk taking behavior due to
market power. In a seminal paper, Keeley (1990), through his theory of charter value,
demonstrated that a rise in bank failures in the U.S during 80s was caused by increased
competition in the banking market. Keeley hypothesized a positive inverse relation between
risk taking behavior and charter value, where charter value is defined as present value of
profits from future operations. In other words, charter value signified the opportunity cost of
going bankrupt. Put simply, since in a more concentrated banking system, individual banks
enjoy higher profits, it would raise the opportunity cost of going bankrupt and so deter banks
from excessive risk taking behavior. In a competitive market, on the other hand, banks would
simply respond to market forces and for reasons like asymmetric information, would be
induced to take on more risks, thus lowering their charter value. Though empirical literature
on the relation between charter value and a banks risk taking behavior is scarce, Keeley and
some other studies do find a positive and significant relation between charter value and a
banks capital holding suggesting the argument to be valid.

Given the empirical fact that a concentrated banking system is more resilient to risks and
runs, the second issue at stake is to trace evidence as to whether a more concentrated banking
system ensures allocative efficiency. After all traditional IO theory suggests that a
concentrated banking sector would exercise its market power in order to extract higher profit.

Though the concentration-monopoly profit nexus has originated from the Structure- ConductPerformance School and will be studied in the next section, for the time being, I summarize
other studies elaborating on whether concentration really translates into monopoly profits for
banks or not? Scholtens (2000) examines the relationship between market structure and the
performance of the banking industry using a dataset of 1000 largest banks in the world
(1988-98 editions). On a national level, the results achieved show a weak and statistically

51

insignificant relation between bank market structure and profitability. To further corroborate
the results, Scholtens (2000) empirically tests the microeconomic performance of 100
international banks. The aggregate result suggests profitability to be positively associated
with banks tier I25 capital and inversely related to size.

Another point, on which market power possibly scores over excessive competition, when it
comes to allocative efficiency, is the ability of a concentrated banking sector to engage more
in relationship lending (refer Ch.3 on why concentration leads to better prospects of
relationship lending) . Petersen and Rajan (1995), using U.S data on 3404 small firms26, test
the relationship-lending hypothesis to examine the effects of a concentrated credit market on
small firms. The authors conclude that: (a) given that distribution of firm qualities remain
constant in all markets and that at least, some firms are credit constrained in one market,
smaller firms are more likely to have access to credit in a concentrated credit market. (b)
Credit should be available cheaper to poor quality firms in a concentrated credit market than
in a competitive market.

A similar study by Beck, Demirguc-Kunt, and Maksimovic (2003) support the findings of
Petersen and Rajan by examining a dataset of developed and developing countries to find any
relation between market structure and its impact on credit availability. Although the authors
find an inverse relation between market structure and credit availability in that firms are more
credit constrained in concentrated markets, the results achieved were really a consequence of
including economies with an under developed financial system and low levels of economic
growth rather than an effect of concentration. As such, when the authors do control for
variables like entry restrictions, ownership structure or other socio-economic indicators like
economic growth and the legal system, the relation between concentration and lower credit
availability is almost insignificant. The authors also find that by reducing restrictions on
banks activities (allowing banks to diversify) may also reverse the negative effects of

25

Tier I capital consists of most reliable and liquid capital holding of a bank. Regulators consider Tier I capital
the core measure of a banks financial strength.
26
Petersen and Rajan classify small firms as firms with a size, in terms of book assets, of $1.05 million; median
size of $130,000 and sales of $2.6 million.

52

competition. Put differently, a concentrated banking system can behave competitively if

there are fewer restrictions on bank activities and well functioning institutions are in place.

Finally, Rajan and Zingales (1998) look at a cross industry, cross country dataset to examine
the effect of concentration on credit availability. Apart from using common variables used in
other studies, Rajan and Zingales apply principles of corporate finance theory to study the
median age of firms till which they are heavily dependant on external finance. Having
established the median age, the authors empirically test whether credit is available more to
such firms in a developed financial system than in a developing or under developed one. As
with other studies, even here the results point towards the need for maintaining an efficient
institutional structure and show that credit constrained firms grow faster in countries having a
well developed financial system. Cetorelli and Gambera (2001) further complement these
findings, by indicating that although concentration has an overall negative effect on credit
markets, the effect is varied across industries and that credit constraint firms grow faster in
economies with a concentrated banking system.

The empirical evidence presented so far suggests that market power, instead of being a
culprit and causing efficiency losses, is in fact an important factor in building and sustaining
a sound banking system. Such a conclusion has serious implications for our debate. Whilst
traditional economic theory suggests market power to be responsible for efficiency losses,
empirical evidence show otherwise and rather put the onus on issues such as contestability
and policy making. In my view, such a trade off occurs or seems to occur because the
theoretical aspect on this debate fails to analyze the subject in a holistic sense in that it fails
to account for the special characteristics of this industry and treats banking like any other
homogeneous industry where output restriction simply translates into loss in consumer
surplus. Empirical studies, on the other hand, do take into account issues such as
contestability and the influence of policies on bank behavior. Obviously, one cannot make
such strong assumptions without probing the issue fully and looking at reasons why
economic theory leads us to such a conclusion.

53

In the next sections, the debate would continue, albeit, from an industrial organization
perspective. Industrial organization holds a burgeoning amount of literature which views
monopoly profits from different angles. While structural approaches such as the StructureConduct-Performance approach attempts to create a direct link between concentration and
profits, Efficiency Structure hypothesis sees such profits as a reward for higher operating
efficiency. Then there is the Non-structural approach which does not discriminate against
market power, rather looks at the contestability aspect. I essentially summarize all the
approaches and give a brief covering empirical evidences produced by using these techniques
in context of banking.

4.2: Structural Approaches to Competition and Banking

The Structure Conduct Performance (SCP hereafter) is the traditional approach in industrial
organization to measure market power in an industry. The approach assumes a stable, casual
relationship between a set of variables like structure i.e. number of participants active in an
industry, conduct i.e. competitive, monopolistic or monopolist behavior and the resultant
performance of that industry i.e. the technical and allocative efficiency of that market. Since
prices are less easily observable, a direct link between the two sets of more easily observed
variables: structure and performance is usually assumed. The basic idea is to establish
relationships between structural variables and market performance that generalize, or hold
across industries.

In the context of banking, applying the SCP approach to study bank behavior in a
concentrated banking structure would imply that the presence of fewer banks would facilitate
market power and thus result in higher lending rates and lower deposit rates. Indeed,
empirical studies done on bank concentration and allocational efficiency during the 1990s
on U.S credit markets found banks to charge higher loan rates and give out lower deposit
rates to customers (see Northcott, 2004; Berger and Hannan, 1989).

54

However, in the 1990s, researchers pointed out to some peculiar characteristics of the SCP
approach which made the results questionable27. Generally speaking, a major problem with
the SCP approach is that it relies heavily on accounting data for measuring market power.
For example, the approach makes use of the rate of return concept based on accounting
principles to measure market power which produces results with significant bias since the
method involved in calculating rate of return differs fundamentally from the one used in
calculating the economic rate of return. Secondly, even where the approach uses the pricecost margin to measure market power, the results, in an economic sense, cannot be fully
admissible since accounting data does not provide useful information on marginal costs and
so tends to be only an approximation to Lerner index.

Apart from these general shortcomings, another limitation of this approach relevant to
banking is that of market delineation. In order to measure concentration (proxy for structure),
one needs to identify the relevant product and geographical market, taking account of all the
substitutes present. This can be challenging in the case of banking since various banks offer
many differentiated and substitutable products at the same time. Also, as an effect of
financial deregulation, a lot of financial products are now being offered by non banking
firms, which makes the process of defining market ever more difficult.

For such reasons, the results obtained on market power in banking using the traditional SCP
approach may only tell half the story. For this reason, the correct methodology would to be
put in place a revised SCP model for the banking markets. Neuberger (1997) develops a
revised version of the SCP approach by incorporating the microeconomic theory of banking.
Since the theory of incomplete information and principle-agent problem figure prominently
in literature on banking, the author considers a framework where all the variables appear
endogenous due to the high degree of inter-dependency between structure, conduct and
performance and the feedback effect on demand conditions and public policy.

Put

differently, the authors integrate market imperfections into the basic demand condition. In
particular, they analyze the impact of asymmetric information and state verification on the

27

See Church and Ware (2000) for a thorough critique of the traditional SCP approach.

55

banks activity, their structure and performance. Figure 5 below shows the revised SCP
framework for the banking sector.

Although Neuberger provides the revised theoretical SCP framework for banking markets,
the paper remains silent regarding the optimal size of the banking firm and stresses on the
need for more research on this issue. However an important finding of this paper is that in
wake of technological developments and important deregulations in the banking industry, the
traditional SCP paradigm is no longer applicable to the universal banks operating in Europe
and United States or for that matter any where else in the world.

A second substantial issue in the structural approach is the efficiency structure hypothesis.
Developed by Demsetz (1973) and Peltzman (1977), the Efficiency Structure (ES) hypothesis
challenges the line of reasoning of the traditional SCP paradigm and offers a competing
explanation of the relation between market structure and performance. The hypothesis claims
that if a bank achieves a higher degree of efficiency than other banks in the market (i.e. its
cost structure is comparatively more effective), its profit maximizing behavior will allow it to
gain market share by reducing prices. Thus, market share is shaped endogenously by banks
performance, so that concentration is a result of the superior efficiency of the leading banks.

Empirically, the hypothesis has found some support. Punt and Van Rooij (2001) examine
links between market structure and profitability among European banks. The authors find
that, on average, both bank profitability and x-efficiency have improved post mergers. Also,
the authors do not find conclusive evidence of monopoly behavior (higher loan rates/ lower
deposit rates) in a consolidated banking market.

However, as one might guess, empirical results depend a lot on the dataset. Studies using
other more recent datasets (e.g. Schlotens 2000) have generally found mixed results, though
similar in spirit. Firstly, empirical findings show profitability and concentration to be
negatively related, which obviously contradicts both the structural theories. And secondly,
support for the ES hypothesis is found to be statistically weak and insignificant. As a result,
one cannot totally rely on such a hypothesis to argue for market power.

56

Figure 5: Revised SCP Framework for banking markets.

(Source: Neuberger1997)

57

Overall, the use of structural approaches to establish a link between concentration and
profitability provides uncertain results and so to confidently single out concentration alone as
a measure to assess the degree of competition in banking markets would be unfair. For such
reasons, we now turn our attention to non-structural approaches used to examine the issue of
market power in banking.

4.3: Non-Structural Approach to Competition and Banking.

In order to overcome problems associated with the structural approaches, more recent studies
have applied non structural approach to study bank performance and market structure.
Although, the non-structural approach includes three models of analysis, namely the Iwata
model, Bresnahan model and the Panzar and Rosse (PR) approach, only the PR approach will
be considered in this paper.

Section 4.3.1: The Panzar and Rosse approach.

The PR model is the most commonly used non structural approach for the banking industry.
The model involves determining the change in revenues earned by a bank as a result of
change in input prices. In a collusive environment, Panzar and Rosse demonstrate that under
profit maximizing conditions, an increase in input prices would reduce a banks total revenue
and output by increasing its marginal cost. So for example, under perfect competition an
increase in input prices would increase marginal cost and revenue by the same amount. On
this principle, an H statistic is calculated which measures the elasticity of revenue with
respect to prices where H=1 implies perfect competition and H=0 implies monopoly and
anything in between signifies monopolistic competition. Thus by using elasticity of revenue
to price on an aggregate level, one can indirectly establish the degree of competition in that
sector.

58

Table 2: Discriminatory power of H.

Source: Bikker and Haaf (2002)

Bikker and Haaf (2002) examine competitive conditions for 23 industrialized countries inside
and outside Europe over approximately 10 years using the PR model. As explained above,
the authors construct the H-statistic based on the elasticity of revenue to price and then relate
this statistic with market structure. Although, the authors find competitiveness to be
negatively related to concentration28, the results are at best weak29. In fact, for all the
countries the H statistic falls between 0 and 1 implying monopolistic competition. Table 3
below shows the results for all the 23 countries for 1997 using a series of techniques such as
the k-concentration ratio and the H-statistic. The authors also mention and compare other
studies done using the PR approach on banking. Table 4 shows the results achieved in such
studies.

Generally speaking, other studies using the PR model echo the main conclusions of the
Bikker and Haaf (2002) study. That competitiveness is negatively related to concentration is
found to be statistically weak.

28

For all the regression equations, the coefficient of the concentration index shows negative signs, indicating
that competition is decreasing with increasing market concentration.
29

According to the authors, if the dummy variable is deleted, the significance of other parameters drops
dramatically.

59

Table 3: Concentration indices, for 23 countries based on total assets (1997)

Source: Bikker and Haaf (2002)

Table 4: PR model results in other studies

Mon= Monopoly, Mn. Comp= Monopolistic Competition

Source: Bikker and Haaf (2002)

60

Finally, Claessens and Laeven (2003) reiterate the findings of other empirical studies based
on the PR model, though using a different and much varied dataset. The authors construct Hstatistics for 50 countries (measuring their competitiveness) and then formally relate these to
a countries regulatory regime and its banking structure such as presence of foreign banks,
degree of liberalization in domestic markets and the kind and degree of entry restrictions.
They conclude that competitiveness of banking markets is determined more by contestable
conditions in that market like openness to foreign players and degree of entry restrictions
rather than the level of concentration in banking markets. In fact the authors find imperfect
competition prevailing in each of the countries tested.

Section 4.4: Some final thoughts

The empirical evidence presented in this chapter takes a holistic view on competition in
banks. As such, the evidence can be broken down into two essential parts which concern
banking. While section 4.1 presents evidence on the stability and efficiency aspect of
banking, the latter sections present evidence which disapprove of the concentration-profit
nexus suggested by the SCP paradigm. All the results presented in this chapter, unless
otherwise stated, are robust, statistically significant and complement theoretical models
presented in the previous chapter. Finally, the evidence suggests that competitiveness in
banking does not depend on the number of banks operating in a market, but on how
contestable the markets are. However, the number of banks does affect the overall resilience
of the financial system. For such reasons, banking markets the world over are allowed certain
degree of market power and therefore demonstrates a monopolistic market structure.

61

Chapter 5:

Debate Concluded

This paper presents an overview of the latest research on the economic role of bank
competition. As such, our transitional journey from the problems faced by the state of Old
York to more realistic yet similar issues facing real world suggests that the topic competition
among banks is not as straightforward as one might wish. Contrary to traditional textbook
wisdom that competition is necessarily welfare enhancing in the banking industry, the issue
of stability in the system has made the debate ever more complicated. While competition
ensures greatest amount of credit is supplied at lowest rates, it also makes banking firms take
on more risks. The important role of the banking industry in an economy and consequently
the special status it commands in an economy also means that the risks attached with
competition can be grave and so worth taking stock of.

To understand the importance such risks pose to an economy, one really has to understand
certain characteristics which differentiate banking operations from other industries and
analyze how these special characteristics, through a multiplier effect, can disrupt an
otherwise sound economy. In particular, as chapter two mentions, banks are special for a
number of reasons, such as:

Banks usually deal (at least partially) with financial contracts (loans and deposits),
which cannot be easily resold, as opposed to financial securities (stocks and bonds),
which enjoy a flourishing secondary market. Therefore banks typically, must hold
these contracts in their balance sheets until the contract expires.

The characteristics of the contracts or securities issued by firms (short-term or longterm loans) are usually different from those of the contracts or securities desired by
investors (time deposits etc.).

If one adds the asymmetric information problem, moral hazard and the agency problem to
this list, then the issue at hand certainly does look more intricate then previously thought. In
particular, these inherent market imperfections in banking can cause banks to fail or cause

62

panic runs on an otherwise sound bank (the sequential service constraint). In light of such
constraints, market power is conceived necessary for maintaining a vibrant and safe financial
system- one that best contributes to economic development.

Another concern in banking which we encountered, argued that a concentrated banking

market would distort allocative efficiency and thus discourage entrepreneurial incentives and
investment in R&D leading to slower pace of technological innovation and productivity
growth. However, a crucial point neglected in such a thought is that credit market efficiency
not only depends on the quantity of credit supplied but also on the quality of credit supplied.
The informational asymmetries and the moral hazard arguments in chapter three helped
highlight how loan default rates can become an increasing function of the number of banks.

Obviously, one can argue that banking markets are not the only one which faces
informational asymmetries or moral hazard problems, then why should it be given special
treatment, in that why should market power not be considered harmful as with other
industries? The key to understanding why market power might be good from a welfare
viewpoint is to take into account the high degree of interdependence and cooperation which
banks are engaged in a financial system. And as such, banks with market power would be
able to preclude spreading of failure or runs from one bank to another. Put differently, the
probability of financial contagion is considerably lower in concentrated markets than in
competitive markets.

Thus, the whole issue of stability introduces a whole new dimension to the social efficiency
debate and presents itself as a trade-off. While competition in banking would ensure
maximum credit supply, pressure banks to innovate more compared to a monopolist bank and
help highlight private information, market power would ensure that banks employ efficient
screening technologies aimed at restricting credit to good borrowers, which can improve
the quality of banks portfolio.

As such this trade-off has some important policy implications. In order to achieve the goal of
maintaining a fine balance between stability and efficiency, the regulators should encourage

63

a market structure which promotes both. While it remains an established fact for some time
now that suggests unleashing competitive forces in a market would bring out maximum
efficiency, literature on how best to achieve stability in banks remains contentious.

Whilst there exists a pro competition school of thought which believes that competition
coupled with stricter monitoring policies like tough disclosure norms, higher capital
requirements and risk based deposit insurance would dissolve this trade-off and promote a
healthy banking system. However, as the idiom two sides to every story goes, research
pertaining to the economic costs of excessive regulation suggests that such an environment
would prove to be sub-optimal as large resources would have to be devoted in order to
implement and monitor such policies across a number of small banks. Also, research on the
effects of deposit insurance in banking (for e.g. see Keeley (1990) suggests that presence of
deposit insurance in credit markets induces banks to take on excessive risks (moral hazard)
and thus increasing the chances of a bank failure or runs. All in all, having a competitive
banking system and then regulating it heavily reveals results which are similar to that in a
concentrated market, but without the benefits of market power (read stability).

A second line of thought suggests allowing a certain degree of market power in banking and
having policies directed at facilitating entry and making markets more contestable. This line
of thought is particularly appealing to the banking sector. First, because having imperfect
competition would give banks a degree of market power and thus allowing them to behave in
a prudent fashion. Secondly, due to the very nature of the industry, imperfect competition
among banks is characterized by Bertrand Competition, under which even two firms
competing can attain results similar to that of perfect competition! In fact, empirical evidence
reviewed on this subject also indicates that concentration in itself should not serve as a sole
indicator for competitive behavior. Instead other factors such as less severe entry restrictions,
fewer restrictions on the activities that banks can perform, well developed financial systems
etc. can still induce banks to behave competitively. After all, it is a well documented fact in
the IO literature that in a contestable market, even a monopolist cannot price above average
cost.

64

Finally, banking markets, like others, are changing rapidly (caused by liberalization and deregulation) and competition and regulation have to adapt to this new environment. Somewhat
paradoxically, both the dangers of excessive competition and excessive market power are
present in this sector and so throws open questions regarding the optimal level of competition
in banking and the role of competition policy in maintaining that desired level.

Although, literature on contestability provides a satisfactory passage to achieve these desired

goals, it should be kept in mind that contestability hinges on a lot of other factors such as the
state of economic development etc. and for such reasons different countries may have
different levels of competition intensity. Regulators in countries with advanced institutional
set-ups such as an efficient legal system and deep financial markets should generally promote
vigorous and healthy rivalry among banking firms since the anticipated social cost of bank
failure would be low. On the contrary, emerging economies and LDCs with weak
institutional setup and high cost of social failure should moderate the intensity of competition
in that should direct policies which overrule stability over efficiency. Nonetheless, if one has
to generalize any conclusions arising from this debate, it is that market power in banking
might not be harmful from a social welfare viewpoint, as traditionally thought of.

65

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