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Banking competition

The global financial crisis reignited the interest of policy makers and academics in bank competition and the role of the state in competition policies (that is, policies and laws that affect the extent to which banks compete).  Some believe that increases in competition and financial innovation in markets such as subprime lending contributed to the financial turmoil. Others worry that the crisis and government support of the largest banks increased banking concentration, reducing competition and access to finance, and potentially contributing to future instability as a result of moral hazard problems associated with too-big-to-fail institutions.

As in other industries, competition in the banking system is desirable for efficiency and maximization of social welfare. However, due to its roles and functions, there are some properties that distinguish it from other industries. It is important to not only make sure that banking sector is competitive and efficient, but also stable.

Measuring and assessing competition

There are several approaches to measuring bank competition. These include decomposition of interest spreads, measures of bank concentration under the so-called “structure-conduct-performance” paradigm, regulatory indicators that measure the contestability of the banking sector, and direct measures of bank pricing behavior or market power based on the “new empirical industrial organization” literature.

An approach used by some studies to analyze bank competition is based on interest spread decomposition. But spreads are outcome measures of efficiency, and in addition to the competition environment, cross-country differences in spreads can reflect macroeconomic performance, the extent of taxation of financial intermediation, the quality of the contractual and judicial environment, and bank-specific factors such as scale and risk preferences. So these effects need to be controlled for before analysis competition.

The so-called structure-conduct-performance paradigm assumes that there is a stable, causal relationship between the structure of the banking industry, firm conduct, and performance. It suggests that fewer and larger firms are more likely to engage in anticompetitive behavior. In this framework, competition is negatively related to measures of concentration, such as the share of assets held by the top three or five largest banks and the Herfindahl index.

According to this approach, banking concentration can be approximated by the concentration ratio—the share of assets held by the k largest banks (typically three or five) in a given economy—or the Herfindahl-Hirschman index (HHI), the sum of the squared market share of each bank in the system. The HHI accounts for the market share of all banks in the system and assigns a larger weight to the biggest banks. Instead, concentration ratios completely ignore the smaller banks in the system. The concentration ratio varies between nearly 0 and 100. The HHI has values up to 10,000. If there is only a single bank that has 100 percent of the market share, the HHI would be 10,000. If there were a large number of market participants with each bank having a market share of almost 0 percent, the HHI would be close to zero.

However, concentration measures are generally not good predictors of competition.  The predictive accuracy of concentration measures on banking competition is challenged by the concept of market contestability. The behavior of banks in contestable markets is determined by threat of entry and exit. Banks are pressured to behave competitively in an industry with low entry restrictions on new banks and easy exit conditions for unprofitable institutions—even if the market is concentrated.

Therefore, instead of using concentration, much of the recent research on the subject focused on direct measures of bank pricing behavior or market power based on the “new empirical industrial organization” literature.  These include the Panzar-Rosse H-statistic, the Lerner index, and the so-called Boone indicator.

The H-statistic captures the elasticity of bank interest revenues to input prices. The H-statistic is calculated in two steps. First, running a regression of the log of gross total revenues (or the log of interest revenues) on log measures of banks’ input prices. Second, adding the estimated coefficients for each input price. Input prices include the price of deposits (commonly measured as the ratio of interest expenses to total deposits), the price of personnel (as captured by the ratio of personnel expenses to assets), and the price of equipment and fixed capital (approximated by the ratio of other operating and administrative expenses to total assets).

Higher values of the H-statistic are associated with more competitive banking systems. Under a monopoly, an increase in input prices results in a rise in marginal costs, a fall in output, and a decline in revenues (because the demand curve is downward sloping), leading to an H-statistic less than or equal to 0. Under perfect competition, an increase in input prices raises both marginal costs and total revenues by the same amount (since the demand curve is perfectly elastic); hence, the H-statistic will equal 1.
Another frequently used measure is based on markups in banking. The indicator, so-called Lerner index, is defined as the difference between output prices and marginal costs (relative to prices). Prices are calculated as total bank revenue over assets, whereas marginal costs are obtained from an estimated translog cost function with respect to output. Higher values of the Lerner index signal less bank competition.

Finally, the Boone indicator is a recent addition to this family of indices. It measures the effect of efficiency on performance in terms of profits. It is calculated as the elasticity of profits to marginal costs. To calculate this elasticity, the log of a measure of profits (such as return on assets) is regressed against a log measure of marginal costs. The elasticity is captured by the coefficient on log marginal costs, which are typically calculated from the first derivative of a translog cost function. The main idea of the Boone indicator is that more-efficient banks achieve higher profits. The more negative the Boone indicator is, the higher the level of competition is in the market, because the effect of reallocation is stronger.

Did competition cause the big financial crisis?

The basic observation that competition increased before the crisis does not necessarily suggest that greater competition in itself spurred the crisis. Recent studies suggest the problem was in other things, in particular in missing incentives for adequate risk management missing, and in lax supervision.  In fact, the run-up to the crisis was characterized by an increase in market power (Anginer, Demirgüç-Kunt, and Zhu, 2012).

The financial crisis—and the subsequent policy responses by governments—may have affected the competitive conduct of financial intermediaries in industrial countries.  Bank competition in developed countries deteriorated during this period, especially in countries that had large credit and housing booms (such as the United States and Spain). This is confirmed by measures such as the Lerner index and the Boone indicator.

Chapter 3 of the Global Financial Development Report 2013 examines bank competition and the role of the state in competition policy in more detail.

Suggested reading:

Anginer, Deniz, Asli Demirgüç-Kunt, and Min Zhu. 2012. “How Does Bank Competition Affect Systemic Stability?” Policy Research Working Paper 5981, World Bank, Washington, DC.

Beck, Thorsten. 2008. “Bank Competition and Financial Stability: Friends or Foes?” Policy Research Working Paper 4656, World Bank, Washington, DC.

Boone, Jan. 2001. “Intensity of Competition and the Incentive to Innovate. International Journal of Industrial Organization 19: 705–26.

Caprio, Gerard, Asli Demirgüç-Kunt, and Edward J. Kane. 2010. “The 2007 Meltdown in Structured Securitization: Searching for Lessons, not Scapegoats.” World Bank Research Observer 25 (1): 125–55.

Panzar, John, and James Rosse. 1982. “Structure, Conduct and Comparative Statistics.” Bell Laboratories Economic Discussion Paper No. 248. Bell Labs Statistics Research Department, Murray Hill, NJ.

Panzar, John, and James Rosse. 1987. “Testing for ‘Monopoly’ Equilibrium.” Journal of Industrial Economics 35: 443–56.

Schaeck, Klaus, Martin Čihák, and Simon Wolfe. 2009. “Are Competitive Banking Systems More Stable?” Journal of Money, Credit, and Banking 41 (4): 711–34.

World Bank. 2012. Global Financial Development Report 2013: Rethinking the Role of the State in Finance. World Bank, Washington, DC (, Chapter 3.